International Project Finance

Group members: Jayesh, Uma, Roopa, Ritesh, Archana, Rajesh Babu & Lakshmi.

Characteristic features of major projects:

• Projects are usually very large & capital intensive• They are often dedicated to a single purpose & none of the equipments can

be used for other purpose• Time for project development & implementation is quite long, returns are

deferred for some years• They are often located at remote sites demanding additional unproductive

investment in infrastructure• They often exceed capacity of a single organization to plan, supply &

construct• They are technically complex demanding resources of skill, manufacturing

& production which are not widely available• Their functions often overflow national boundaries, products have

international impact

PROJECT FINANCING

• Project financing is a special case of financing in which lender relies on repayment from the net cash flow generated by the project.

• Project finance is provided against assets of and the rights in a particular project rather than against the borrower’s balance sheet.

• Financers are therefore concerned to analyze the risks associated with the project before they accept the investment opportunity which it represents.

• The cost and terms of financing reflect the financier’s view about the riskiness of the project

Project financing is required in a number of situations:

• For companies in general, to avoid constraints on corporate borrowing

• For project sponsors, where one party one party is not able to take on a major project by itself, to spread the risk among several parties to lessen the financial impact and to increase their capacity to undertake more projects

• For multinational corporations to protect their corporate balance sheets from the impact of large projects

• For governments to share the costs and risks of exploiting natural resources

• For governments to increase foreign capital investment in the country at no cost to the country

Characteristics of financing strategy

• The project will fail, no matter what its technical merit, unless enough finance is available to complete it

• The design, implementation and management of the financing demands the same level of commitment of planning and management as the project itself

• Financial planning should begin at the same time, or earlier, than technical project planning

• While financing package is likely to reflect the complexity of project, finance has some inherent characteristics which themselves add to the complexity of undertaking.

Risks in IPF

POLITICAL RISKDescription:Political instabilityConfiscation: Government takeover without compensation.Expropriation: Government takeover with compensation.Nationalization: Conversion from private to public (governmental) ownership - with (some) compensation.

Mitigation:Purchasing political risk insurance.Protect the firm by hiring local nationals, acting responsibly in the eyes of the host governmentEntering into joint ventures, making the subsidiary reliant on the parent company,

INFLATION RISKDescription:This risk represents the possibility that the actual inflation rate will exceed the risk projected in the initial stages of project set-up

Mitigation:Inflation risk may be mitigated by including an actual index, based on inflation, in the contract’s pricing formula, or by entering into long-term supply contracts with predetermined prices (these contracts increase the counterparty credit risk). To the extent that the risk cannot be controlled by the private sector, the public sector may decide to retain the risk, reducing the cost of the project.

EXCHANGE RATE CURRENCY RISKDescription:The volatility of the exchange rate of one currency for another The cash flow from a foreign project are in foreign currency and therefore subject to currency risk

Mitigation:Companies could avoid exchange rate risk by doing business exclusively in their own countries—but for large businesses (and increasingly, for smaller ones) this is hardly a realistic proposition. A much more practical option is to insist on using one’s own currency for all transactions. However, asking all customers to use dollars (for example) is inflexible, and forces them to take on all the risk (it’s not likely to go down well)A more pragmatic approach is to learn about the fundamentals of exchange rate risk (such as study of Purchasing Power Parity (PPP), International Fisher Effect (IFE), Unbiased Forward Rate) in order to reduce its negative impact.

TAX RISK

Description:Tax codes and policies differ from country to country, but all countries impose income taxes on foreign companiesCountries tax income earned outside their boundaries by firms based in their country This may lead to double taxation whereby the firm is taxed by both the host-country government and the parent firm’s home government

Mitigation:Existence or otherwise of double taxation avoidance agreements help obtain credit for the taxes paid abroad to the parent firmThe possibility of using transfer prices to reduce the tax burden further

CULTURAL AND INSTITUTIONAL RISKS

Description:Restrictions w.r.t ownership structureDifferences in human resource normsDifferences in religious heritageNepotism and corruption in the host countryProtection of Intellectual Property Rights (IPR)Protectionism

Mitigation:Awareness and careful study of the hosts cultural & institutional Need to draw some legal agreement with the host country to protect IPRNeed for awareness about the sectors that are highly protected, e.g. defence, agriculture, etc

BLOCKED FUNDS

Description:Some countries may require that the earnings be reinvested locally for a certain period of time before they can be remitted to the parent (Or can be taken out with heavy penalties in the form of taxes)Both temporary and long term impact of funds’ blockage on expected return of investment needs careful assessment

Mitigation:Investing these funds locally in a subsidiary Or Joint Venture to make best use of blocked fundsBorrow locally to avoid problems of repayment of external loans.

Project Appraisal

Investment Criteria

Discounting Criteria Net Present Value Adjusted Present Value Benefit Cost Ratio Internal rate of return

Non-Discounting Criteria Payback Period Accounting Rate of Return

Project Evaluation Techniques

Net Present Value(NPV)

The NPV – Sum of the present values of all the cash flows; includes +ve & –ve cash flow

where I0 = initial cash outlay Investment rule:

CFt= net cash flow at t Accept project if NPV > 0.

k = cost of capital Reject project if NPV < 0.

n = investment horizon

Adjusted Present Value (APV)

where k* = cost of all-equity financing

Tt = tax savings in year t (=id Dt)

id = before-tax cost of HC debt

St = before-tax HC value of subsidies (rate of subsidy x par value loans)

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Project Evaluation Techniques

Internal Rate of Return(IRR)

IRR is the discount rate at which the NPV of a project becomes zero

Investment =

Investment rule:Accept project if IRR > Cost of Capital.Reject project if IRR < Cost of Capital.

• Benefit Cost Ratio(BCR)

The BCR is the ratio of benefits per dollar of cost (both in PV terms). Is a numerical value, not usually displayed in currency terms.BCR = (PV of benefits)/(PV of costs)

Investment rule:Accept project if BCR > 1.Reject project if BCR < 1.

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Project Evaluation Techniques

• Payback Period

PBP<RPP Accept

PBP > RPP Reject

• Accounting Rate of Return(ARR)ARR = Profit After Tax/Book value of the investment

Project Evaluation Techniques

Home Currency Approach Convert all the dollar cash flows into rupees(forecasted

exchange rates) Calculate the NPV, IRR in rupees (using rupee discount rate)

Foreign Currency Approach Calculate the NPV, IRR in dollars(use dollar discount rate) Convert the dollar NPV, IRR into rupees(use the spot exchange

rate)

Project Cash flows

Cash Flow Components Initial Investment Operating Cash Inflows Terminal cash inflow

Principles of cash flow estimation Separation Principal Incremental Principle Post tax principle Consistency principle

Exhibit 12.1 from Prasanna Chandra

Cash Flow in the international context

Project Cash Flows versus Parent Cash Flows.

step-wise approach to the evaluation of foreign projects

First, treat the project as a branch operation of the parent company. All the cash flows generated by the project belong by definition to the parent since the project has no distinct identity. This allows us to focus on the pure economics of the project.

Next, consider the project as a fully equity-financed, wholly owned subsidiary of the parent, incorporated under the host country laws, having a distinct legal identity. Now, we focus on the various financial arrangements between the parent and the subsidiary and consider what means are available to the parent to increase the cash flow transfers between the subsidiary and the parent and minimize the overall tax burden.

Finally, as in the case of a domestic project, incorporate the effects of external financing such as the interest tax shield.

Biases in Cash Flow Estimation

Overstatement of Profitability Intentional overstatement Lack of experience Myopic euphoria Capital rationing

Under-statement of Profitability Salvage values are under-estimated Intangible benefits are ignored The value of future options is overlooked

Distinguish Foreign Project from Domestic Project

Reliable exchange rate forecast are difficult to obtainLinking the performance of the project with the exchange

rate is difficult.Treatment of dividend income by home country

governmentTreatment of other type of transfers such as interest,

royalties etc between subsidiary and the parent.Double Taxation.

Sourcing of Funds

Source of Fund

Long Term Short Term

Equity Debt Euro debtOverdraft

PROJECT FINANCING – Long Term

Identifying sources of finance

Identifying suitable sources of finance is the first step in planning finance for a project.

• Debt: Borrower has the obligation to repay. Debt also usually carries obligation to pay interest and to adhere to a prearranged repayment schedule. The lender has priority claim if borrower goes into liquidation.

• Equity: Funds subscribed by the shareholders from their own resources. There is no guarantee that the dividend will be paid and investors tend to loose their money if the project fails to perform. Equity shareholders have the last claim if the project goes into liquidation.

• Euro Bonds: Issued in international markets in different currencies

The main sources of debt finance are:• Commercial banks• Multilateral lending institutions• Suppliers of equipment & services for the project• Suppliers of raw materials to the project• Buyers of output from the project

The main sources of equity finance are:• Corporate cash flow generated by existing business operations• Corporate or individual investors, or funds raised through stock markets• Joint venture partners• Government subscriptions & aids• Multilateral investment institutions• Venture capitalists

PROJECT FINANCING – Long Term

Short Term & Unconventional Funds

Unconventional Sources of Project financing:

• Overdraft: By Local Banks• Eurocurrency Market:- European banks providing short term loans• Leasing: Use of project assets through off-balance sheet financing• Forfeiting: Sale of financial instruments due to mature in future• Counter-Trade: Seller accepts goods or services in lieu of cash payments• Switch Trading: Making use, via a third party, of uncleared credit surpluses

arising from bilateral trade agreements• Offset: Exporter of technically advanced project incorporates an agreed

value of materials, equipment & services supplied by the buyer.

PROJECT FINANCING – Short Term / Unconventional

Unconventional Sources of Project financing:

• Franchise Financing: Engineering & construction contractors become equity holding joint venture partners for the project they design & build.

• Debt/Equity Swapping: Multinational technology owner buys host country debt at a discount. The debt is redeemed in local currency at favourable rate of exchange for setting up a local company. The local company uses transferred technology to earn foreign exchange, replace imports & generate local employment.

• Build – Operate – Transfer (BOT): Government grants concession to a project company to build a facility and operate it on commercial basis. Facility is transferred to government at the end of the concession.

PROJECT FINANCING – Short Term / Unconventional

FDI

Foreign Direct Investments

Foreign Direct Investments