Project Finance Meaning, Nature, Components, Sources

Table of Contents:-

  • Meaning of Project Finance
  • Nature of Project Finance
  • Capital Structure in Project Finance
  • Components of Capital Structure in Project Finance
  • Sources of Project Finance

Meaning of Project Finance

Project finance is the process of securing funds necessary to support an economically different capital investment proposal. In this context, lenders mainly depend on the projected cash flow from the project to meet the obligations of their loans.

The term ‘project finance’ typically denotes a financing structure characterized by non-recourse or limited recourse. In this structure, debt, equity, and credit enhancement are integrated for the construction, operation, or refinancing of a specific facility within a capital-intensive industry. Lenders evaluate credit based on the projected revenues from the facility’s operation rather than the general assets or credit of the facility’s sponsor. They depend on the facility’s assets, including revenue-generating contracts and other cash flows, as collateral for the debt.

In project financing, the debt terms are not based on the sponsor’s credit support or the value of the project’s physical assets. Instead, project performance—both technically and economically—forms the core of project finance.

Nature of Project Finance

Following is the nature of project finance:

1) It is usually raised for a new project rather than an established business (although project finance loans may be re-financed).

2) It is provided for a ring-fenced project (i.e., one which is legally and economically self-contained through a special purpose legal entity (usually a company) whose only business is the project (the Project Company).

3) There are no guarantees from the investors in the Project Company (non-recourse finance), or only limited guarantees (limited-recourse finance), for the project finance debt.

4) There is a high ratio of debt to equity (leverage or gearing) – roughly speaking, project finance debt may cover 70%-90% of the cost of a project.

5) The main security for lenders is the project company’s contracts, licenses, or ownership of rights to natural resources, the project company’s physical assets are likely to be worth much less than the debt if they an sold off after a default on the financing.

6) Lenders rely on the future cash flow projected to be generated by the project for interest and defer payment (debt service), rather than the value of its assets or analysis of historical financial results.

Capital Structure in Project Finance

Capital structure represents the interconnection among different kinds of long-term capital. a company secures long-term capital by issuing common shares, occasionally complemented by preference shares. The share capital is often supplemented by debenture capital and other long-term borrowed capital.

The capital structure of a business enterprise is thus, related to the long-term financial requirements of the business enterprise.

According to Gerstenberg, “Capital structure of a company refers to the composition or make-up of capitalization and it includes all long-term capital resources viz: loans, reserves, shares and bonds”.

Components of Capital Structure in Project Finance

The long-term funds of capital structure can broadly be divided into two categories, viz., owners’ capital and borrowed capital as discussed below:

1) Owners Capital

The following items are included in the owners’ capital:

i) Equity Shares: Equity shares are a fundamental source for financing the activities of s business. Among all the sources of finance, the cost of equity capital is considered to be the highest, as its holders bear the maximum risk of the business. The residual remaining after paying claims of all the other investors belongs to equity shareholders.

ii) Preference Shares: Those shares which carry the following preferential rights are termed preference shares:

a) A preferential right as to the payment of dividends during the lifetime of a company.

b) Preferential right regarding the return of capital during the company’s winding-up. These shares carry a right to dividend at a fixed rate before any dividend is paid to equity shareholders.

iii) Retained Earnings: Retained earnings or Ploughing back of profits are considered to be the best source of internal financing. This type of financing is considered to be the most convenient as no efforts are required to raise such finance.

2) Borrowed Capital

Borrowed capital comprises the following:

i) Term Loans: Term loans are loans provided by banks and other financial institutions which carry a fixed rate of interest for a period of three or more years. Term loans may be mortgaged or simple.

ii) Debentures: A debenture is an acknowledgement of debt or loan raised by a company. The company has to pay interest to debenture holders at an agreed rate under contractual obligation.

Sources of Project Finance

Following are the various sources of project finance:

1) Shareholders

These are public or private institutions, investors or individuals who provide the quasi-equity or equity in a company. Sources of equity include the following:

i) Venture capital companies,

ii) Retained profit of a company,

iii) International investment institutions such as the World Bank,

iv) Funds raised through the stock market,

v) Joint venture partners,

2) Banks

Banks and other financial institutions are the primary providers of debt. Commercial banks are the most accessible to most project investors, and they can be categorized into retail banks, which offer financing at the local level, and merchant banks. There is a large choice available for companies raising finance, and this has led to intense competition. In choosing a bank, the decision will not be so much based on the interest rate charged as on the following factors:

i) The size of the bank,

ii) The experience in financing that type of project, and

iii) Any support they may offer with financial engineering.

3) International Financial Markets

International financial markets provide an alternative to domestic markets, offering easy access to foreign sources of funds. There are many, but the two most important are the Eurocurrency and Eurobond markets. The Eurobond and Eurocurrency markets are the most efficient in the world which provides the smooth movement of funds. They provide short-term finance at competitive rates but are primarily for large organizations.

4) Institutions

The institutions, i.e., insurance funds, pension funds and trust funds, generally require a fixed, steady income stream and a low level of risk when lending money or making an investment. They will generally consider construction developments only on prime sites with few planning problems, preferably opting for a freehold pre-let scheme and involving an established developer.

They usually look for large schemes in which to invest. However, the institutions are becoming more flexible and may consider short-term finance. They have also become more prepared to undertake their developments.

5) Finance for Overseas Projects

Several additional sources of finance are open to overseas projects, in particular.

6) National or International Development Banks

National development organizations and regional or international agencies sometimes offer long-term loans for certain classes of projects at low rates of interest. Each organization or agency has its lending criteria and the eligibility of a specific project will depend on its size, purpose and sponsors.

Development banks tend to take a long time to evaluate a project and are likely to impose conditions such as requiring all construction and equipment contracts to undergo competitive tendering. However, they can help attract other sources of finance once the project has been approved and will finance supporting infrastructure.

7) Export Credit Finance

Export credit finance should be considered where a project requires capital goods and associated services to be imported because

i) The term of the loan can sometimes be longer than the term for commercial funds.

ii) The rate of interest is often subsidized and fixed for the life of the loan.

iii) The loan is very often available in both local and foreign currency.

iv) The buyer credit itself will provide for a loan of up to 85% of the cost of eligible goods.

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