Understanding Project Finance

8/4/2019 Understanding Project Finance

1/39

Dinesh Agrawal CA, MBA1

Dinesh Agrawal CA, MBA

Aug 06, 2011

UNDERSTANDINGPROJECT FINANCE


2/39


FLOW OF THEPRESENTATION Introduction;

Meaning;

Let us understand the subject inform, spirit and substance;

Time for case studies;


3/39


LOOK BACK Historically, GOI laid emphasis on industrialization through successive Five Year

Plans;

Rapid industrial development needed massive investment;

Prior to independence, there were no institutional arrangements for term finance.

GOI, therefore, established the following financial institutions: Indl. Finance Corporation of India (1948) Indl. Credit & Inv. Corpn. of India (1955) Indl. Development Bank of India (1964) & Indl. Reconstruction Bank of India (1971) Similarly, State Governments also established SFCs in their respective states.


4/39


LOOK BACK (CONTD.) For long, commercial banks confined their lending to meet WC requirements only

and they did not play any active role in extending term finance;

However, with increasing proportion of Term Deposits in their deposit portfolioand the paucity of resources in the country, it was felt that banks could enter thefield of term finance, in a role complementary to that of Term Lending Institutions.

And therefore with have ICICI Banks, IDBI Banks of the world


5/39


PROJECT BACKGROUND The purpose of term assistance is to meet a part of the capital expenditure of a

project.

A project can be defined as A scheme of things to be done during aspecified period in future for deriving expected benefits undercertain assumed conditions.

A project may be in the nature of setting up a new industrial unit, modernisation,expansion, diversification and promotion of R&D.


6/39


PROJECT BACKGROUND (CONTD 1) To set up a project, certain capital expenditure needs to be incurred in acquiring

assets such as L&B, P&M and other infrastructural facilities like roads, watersupply, railway sidings, etc., in addition to the Preliminary / Pre-OperativeExpenses and margin on WC Limits

Where promoters of a project are unable to meet the entire capital expenditure

out of their own resources, Term Loans are sanctioned to supplement thepromoters contribution;

Promoters of an industrial project can constitute themselves into any of thefollowing forms of business organisations to implement the project : SoleProprietorship, JHF, Partnership, Co-operative Society & Joint Stock Company.

Our discussion of the subject would revolve around Joint Stock Company as

Promoter(s).


7/39


PROJECT BACKGROUND (CONTD 2) The Promotion Stage is a crucial stage in the entire life cycle of a project.

Promotion in relation to a project will comprise broadly the following functions:

Identification of aproject Feasibilityinvestigation

Assemblingthe

proposition

Financingthe

proposition


8/39


IDENTIFICATION OF A PROJECT The first step in the project promotion is the identification of a project. An

industrial project originates as an idea in a promoter when he observes theexistence of a potential market for a certain product;

The promoter, on the basis of his experience, background and ability, thenconsiders the feasibility of manufacturing and marketing the product at a

remunerative price;

There should be an unsatisfied demand.


9/39


FEASIBILITY INVESTIGATION A detailed feasibility study is a costly exercise. It is, therefore, desirable that,before it is undertaken, marketability of the product to be manufactured is firmlyestablished;

There are agencies, specialising in market research, which conduct such marketstudies. Promoters may take advantage of their services;

A market study aims at assessing the aggregate demand for a product;

The promoter will now undertake the detailed feasibility investigation proper,comprising two feasibility studies:

i) The Technical Feasibility Study

ii) The Economic Feasibility Study


10/39


FEASIBILITY INVESTIGATION - TECHNICAL FEASIBILITY Technical Feasibility Study covers the following aspects:

Location of the project

Lay-out of the Plant

Size of the Plant

Factory construction

Manufacturing process / Technology

Process Design

Product Design

Scale of Operation

Infrastructural facilities


11/39


FEASIBILITY INVESTIGATION - ECONOMIC FEASIBILITY The prime objective of setting up a project is to derive a fair return on the

investment.

Economic Feasibility Study, therefore, concerns itself withmatching of economic resources with the physical requirements ofa project and determining the viability of investment therein.


12/39


ASSEMBLING THE PROPOSITION COP When a promoter is satisfied about the technical feasibility and economic

viability of a project, the next task is to work out the Cost of the Project and theMeans of financing it.

The Cost of the Project would broadly include: (a) L&B

(b) P&M (c) Misc. Fixed Assets (d) Technical Know-how, Engg. & Consultancy fees (e) Preliminary and Pre-operative expenses (f) Provision for contingencies (g) Margin on WC Limits


13/39


FINANCING THE PROPOSITION Setting up of a project involves acquisition of Fixed Assets which facilitate the

process of production;

Fixed Assets have a relatively longer life and are generally not meant for resale;

They are required to be retained over a period of time to exploit their productive

potential; C/A go through the operating cycle of RM, WIP and FG, which when sold bring

in cash. This cycle is generally completed in a short period of less than one year.


14/39


FINANCING THE PROPOSITION (CONTD 1) Thus, investment in C/A is realised over a short term, while investment in Fixed Assets

is long term in nature;

It is realised through surplus generated in the form of Net Profits, Depreciation andother non-cash write-offs;

As it takes a long time for the Fixed Assets to pay for themselves, the Promoter should

raise suitable long term funds to finance a project; Keeping the foregoing in view, the Promoter will explore the financial feasibility of the

project by examining :-

a) The possible long term sources of finance;

b) The feasible financial leverage;

c) The expected return on the investment;


15/39


FINANCING THE PROPOSITION (CONTD 2)

Long TermSources

OwnedCapital

ShareCapital

RetainedEarnings

BorrowedCapital

DebenturesLong Term

LoansPublic

Deposits


16/39


FINANCING THE PROPOSITION (LONG TERM SOURCES) The aggregate amount of finance raised for financing a project is referred to as

Capital, comprising two components:-

(a) Owned Capital and (b) Borrowed Capital.

The other sources of long term funds are:-

(a) Capital Subsidy applicable to projects coming up in certain notifiedbackward areas, and;

(b) Interest free sales tax loans offered by State Governments.


17/39


FINANCING THE PROPOSITION (FINANCIAL LEVERAGE)

After considering availability of long terms sources of finance, the Promoter willdecide about a suitable financial structure for the Company;

It will depend upon the financial leverage envisaged in the combination of sources offinance under the two categories, viz., Owned Capital and Borrowed Capital.

Few projects can be financed entirely by equity or debt;

The divergent interests of debt and equity are brought into alignment by the conceptof Debt / Equity gearing which determines the level of debt that can be supported bya given quantum of equity;

For this purpose, Debt means Funded Debt including all term liabilities and equity willinclude Share Capital and retained earnings, if available;

No standard D/E Ratio can be prescribed No never


18/39


FINANCING THE PROPOSITION (RETURN ON INVESTMENT)

The most important and widely used Capital Investment Evaluation techniquesare:

Pay-back Method

Net Terminal Surplus Method

Excess Present Value Method Internal Rate of Return Method


19/39



The object of Pay-back Method is to find out the period of time required forrecovering the entire amount of investment made in a project.

The cash flows (Net Profit + Depreciation + Other non-cash write-offs) arecompared with the outlay on the project to determine the pay-back period. Yearsto pay back would be:

Total Investment

Cash Flow per annum


20/39



Net Terminal Surplus Method employs the concept of compounding whichinvolves re-investing the simple interest earned each year along with theprincipal so that the principal grows each year by the amount of interest earnedduring the previous year and interest being calculated on the increased principalalso grows.

Future Value = Principal x (1+i)n


21/39



Internal Rate of Return Method It is that rate at which the sum of thediscounted cash flows is equal to the investment outlay.

In other words, IRR is the rate which makes the Present Value (PV) of benefitsequal to the Present Value of costs or reduces the Net Present Value (NPV) tozero.

The object of this method is to find the rate of return which a project is likely toearn over its useful life.


22/39


TYPES OF TERM ASSISTANCE

The types of term assistance extended by the Bank can be broadly classified into:

I] Term Loans (Incl. Forex Loans)

II] Deferred Payment Guarantees

III] Bill Discounting Facilities

IV] Underwriting of Shares / Debentures


23/39


TYPES OF TERM ASSISTANCE TERM LOAN

A Term Loan is a loan granted for a fixed term of not less than one year, intendednormally for financing fixed assets acquired / to be acquired, carrying interest ata specified rate, and scheduled for repayment in installments

Depending on the term for which the said terms loans are granted, they could beclassified into (a) Short Term Loans (b) Medium Term Loans and (c) Long Term

Loans.


24/39


TYPES OF TERM ASSISTANCE DPG

Deferred Payment Guarantee (DPG) is a contract to pay to the supplier the priceof machinery, supplied by him on deferred terms, in agreed installments withstipulated interest on the respective due dates in case of default in paymentthereof by the buyer;

A DPG is, in many respects, a substitute for a Term Loan and, as far as the buyer

of P&M is concerned, it serves the same purposes as a Term Loan;

Standards of appraisal are the same as TL.


25/39


TYPES OF TERM ASSISTANCE BILLS DISCOUNTING

Under a contract for sale of machinery on deferred payment basis, the balanceremaining to be paid after the initial down payment represents the deferredreceivables of the seller.

Thus, the funds of the seller get blocked for unduly long periods and the sellerrequires finance against such deferred receivables to replenish his Working

Capital; To facilitate availment of finance against the deferred receivables, the seller

usually draws a series of usance bills with graded maturities to coincide with thedue dates of payment of the relative installments (including applicable interest).

The usance bills drawn by the seller will be accepted by the buyer before theyare discounted by the sellers banker.


26/39


TYPES OF TERM ASSISTANCE U/W OF SHARES

The necessity for underwriting arrangement arises only in the case of a Public LimitedCompany resorting to raise through the capital issue market, a part of the ShareCapital for part-financing a project;

Underwriting is a contract whereby a person agrees, in consideration, to take up aspecified number of shares or debentures or amount of debenture stock to be offeredto the public, in the event of the public not subscribing for them;

Underwriting as a business will come under the scope of Investment Banking asdistinct from Commercial Banking;

In view of this, therefore, a high degree of selectivity should continue to be exercisedin undertaking underwriting business;

However, the business stemmed not so much from the point of view of earnings on theinvestment as from the consideration that no viable project enjoying national priorityshould suffer for want of underwriting support.


27/39


PROJECT APPRAISAL

The purpose of Project Appraisal is toascertain whether the project will be

sound technically, economically,Financially, and managerially andultimately viable as a commercialproposition.


28/39


PROJECT APPRAISAL

The appraisal of a project will involve the examination of:

a) Technical Feasibility : To determine the suitability of the technology selectedand the adequacy of the technical investigation, and design;

b) Economic Feasibility : To determine the conduciveness of economic parametersto setting up the project and their impact on the scale of operations.

c) Financial Feasibility : To determine the accuracy of cost estimates, suitability ofthe envisaged pattern of financing and general soundness of the capital structure.

d) Commercial Viability : To ascertain the extent of profitability of the project andits sufficiency in relation to the repayment obligations pertaining to term finance.

e) Managerial Competency : To ascertain that competent men are behind theproject to ensure its successful implementation and efficient management aftercommencement of commercial production.


29/39


PROJECT APPRAISAL (CONTD 2)

A project should also be examined, wherever appropriate, from the point of view of itsvalue to the national economy in terms of socio-economic benefits like generation ofemployment opportunities, forex earnings, the quantum of import substitution, etc...;

The first step in Project Appraisal is to find out whether the project is prima facieacceptable by examining salient features such as:

The background and experience of the applicants, particularly in the proposedline of activity;

The potential demand for the product;

The availability of the required inputs, utilities and other infrastructural facilities;

Whether the project is in keeping with the priorities, if any, laid down by theGovernment.


30/39



The original application may not contain all the basic data / information;

In such cases, it may be necessary to interview the applicants and elicit all thenecessary data / information with a view to forming an overall idea about thegeneral feasibility of the project;

After satisfying itself about the prima facie acceptability of the project, the Branchmay call for from the promoters, an Application, containing the followingessential data / information, such as:


31/39



Particulars of the project along with a copy of the Project Report furnishing details of thetechnology, manufacturing process, availability of construction / production facilities, etc;

Estimates of cost of the project detailing the itemized assets acquired / to be acquired,inclusive of Preliminary / Pre-operative Expenses and WC margin requirements;

Details of the proposed means of financing indicating the extent of promoters contribution,

the quantum of Share Capital to be raised by public issue, the composition of the borrowedcapital portion with particulars of Term Loans, DPGs, Foreign Currency Loans, etc.

WC requirements at the peak level (i.e., when the level of Gross Current Assets is at thepeak) during the first year of operations after the commencement of commercial productionand the banking arrangements to be made for financing the WC requirements.


32/39



Project Implementation Schedule.

Organisational set up along with a list of Board of Directors and indicating thequalifications, experience and competence of:-

(i) The key personnel to be in charge of implementation of the project during theconstruction period and

(ii) The executives to be in charge of the functional areas of purchase, production,marketing and finance after commencement of commercial production.


33/39



Demand projection based on the overall market prospects together with a copy of themarket survey report;

Estimates of sales, CoP and profitability;

Projected P&L Account and B/S for the operating years during the currency of the Banksterm assistance;

Proposed amortisation schedule, i.e., repayment programme;

Projected Funds Flow Statement covering both the construction period and the subsequentoperating years during the currency of the Term Loan;

Details of the nature and value of the securities offered;

Consents from the Government / other authorities and any other relevant information.


34/39



In respect of existing concerns, in addition to this information, particulars regarding thehistory of the concern, its past performance, present financial position, etc., should also becalled for;

The Application completed in all respects and duly signed by the authorised signatories ofthe Company will form the basis for the detailed appraisal of the project;

An inspection of the project site (or factory in the case of existing units) is a must; Each project has to be examined in proper perspective having due regard to its nature, size

and scope;

Although the basic techniques employed for appraising the viability of various projects aremore or less the same, there could be no standard or uniform approach for appraising allprojects.


35/39



The ultimate objective of the appraisal exercise is to ascertain the viability of a project witha view to ensuring the repayment of the borrowers obligations under the Banks termassistance;

Therefore, it is not so much the quantum of the proposed term assistance as the prospects ofits repayment that should weigh with the Branch while appraising a project.

In project appraisal, nothing should be assumed or taken for granted; All the data / information should be checked and, wherever possible, counter-checked

through inter-firm and inter-industry comparisons;

It should be borne in mind that Healthy scepticism is a cardinal virtue in projectappraisal.


36/39


PROJECT APPRAISAL MEMORANDUM

1. PROPOSAL

Nature of proposal;

Purpose : New project, expansion, modernisation, diversification or for any other approved purpose

2. BRIEF HISTORY

Brief account of corporate history; MA & AA; Regd. address; Present organisational set up with BoD; Qualifications, experience and background;Line of activities, Financial position, etc., of Associate Concerns; Overall structure of inter-corporate investments

3. PAST PERFORMANCE

Summary of Company's past performance in terms of licensed / installed / operating capacities, sales, operating profit and Net Profit for

the past 3 years; Capacity utilisation; Sales & profitability; Dividend policy; Capital expenditure programmes implemented by the Company

during the past 3 years and how they were financed; Company's management-labour relations

4. PRESENT FINANCIAL POSITION

Company's audited Balance Sheets & P/L Accounts for the past 3 years with analysis; Company's Capital structure; Summarise conclusions

of financial analysis; Method of depreciation; Revaluation of F/A; Record of major defaults; Position of Company's tax assessment; Contingent

Liabilities; Pending suits; Qualifications / Adverse remarks by auditors



37/39



5. PROJECT

(a) Description of the project (Modernisation, expansion, diversification or a new venture) ; Standing, experience and reliability of

outside agency who prepared the Project Report; (b) Collaboration Arrangement (Technical or Financial); (c) Technical Feasibility covering

suitability of technology, size & location of plant, technical arrangements & mfg. process (d) Financial Feasibility covering Cost of Project & Means of Finance

6. PROJECT IMPLEMENTATION SCHEDULE

With reference to Bar Chart or PERT / CPM Chart and in the light of actual implementation; Main stages in the project implementation and whether the timeschedule for construction, erection / installation of P&M, start-up / trial run, commencement of commercial production is reasonable & acceptable

7. PRODUCTION FACTORS

(a) Mfg. Process - Basis of selection & justification; (b) Raw Materials - Imported / Indigenous, Names of main suppliers, Pattern of unit prices & fluctuation;

(c) Utilities & Essential Services - Requirements of power, fuel, water, transport, railway siding with comments on adequacy of arrangements, treatment

and disposal of effluents; (d) Operating Organisation - Experience and expertise of Managerial / Technical personnel, other staff required

8. WORKING CAPITAL REQUIREMENTS

Assessment of total WC requirements at the peak level (GCA) during the first year of operations after commencement of commercial production;

sharing of business among member banks; financing of additional WC requirments in case of existing companies



38/39



9. MARKETING

(a) Sales prospects and underlying assumptions, demand projections on the basis of past consumption, total supply position, general condition of industry

(b) Selling Price - Trend to see whether stable, Govt. price controls, quota systems, etc.; (c) Propsects for exports - Export obligations;

(d) Marketing Organisation - Adequacy, Distributors / Selling Agents, Terms of arrangement, remuneration, competence, Asso. Concerns - Siphoning of profits

10. COMMERCIAL VIABILITY - CoP & PROFITABILITY

(A) Sales Volume / Value - (a) Volume; (b) No. of working days; (c) Capacity utilisation; (d) Value (B) CoP - (a) Matls. consumed; (b) Utilities (PW&F); (c) Wages & Salaries(d) Factory Overheads; (e) Depreciation - SLM / WDV- Consistency; (f) Selling Exp.; (g) Financial Exp.; (h) Admn. Exp.; (i) Royalty & Know-how; (j) Preliminary / Pre-operative

Exp.; (k) Taxation (C) Profitability (CMA Data and ratios) (D) Inter-firm comparison

11. COMMERCIAL VIABILITY - DSCR & REPAYMENT PROGRAMME

(a) DSCR (Gross) and (Net) ['Core Test' Ratio], Margin of safety and extent of risk coverage; (b) Break-Even Analysis - For first full year of production and

the year of maximum capacity utilisation; (c) Cost-Volume-Price (CVP) or Senstivity Analysis - For the year with operating profit nearest to the average operating profit to

determine 'Span of Resiliency' of the project; (d) Repayment Programme based on the above factors and initial moratorium (start-up) period

12. FUNDS FLOW ANALYSIS

Funds Flows to be divided into Long Term Funds Flows and Short Term Funds Flows - Dif. would indicate Long Term Surplus or Deficit / Movements in C/A & OCL leading to

increase or decrease in WCG; Essential expenditure on F/A, repayment obligations, taxes and dividends are fully provided for; Cash generation would be adequate to meet

all commitments during the entire repayment period.



39/39


CONCLUSION

..chance favours only the prepared mind

- Louis Pasteur

Understanding Project Finance

Documents

Transcript of Understanding Project Finance