PROJECT FINANCE(NOTES)

LESSON ONE

OVERVIEW

What exactly is 'project finance'? The term appears frequently in the press, particularly in
relation to infrastructure, public and private venture capital requirements. The press frequently
refers to large projects, such as construction of Highways, Eurotunnel, metro systems, and
airports as examples of infrastructure projects. It is a technique that has been used to raise vast
sums of capital and will continue to do so in both developed and developing countries for the
foreseeable future.

While project finance has some similarities to syndicated lending, there are a number of
differences that make it a distinct discipline in its own right, effectively a subset of syndicated
lending.

Project finance is a non-recourse or limited recourse financing structure that combines debt,
equity, and credit enhancement for the construction and operation, or refinancing, of a specific
facility in a capital-intensive industry.

Typically, credit appraisals and debt terms are based on project cash flow, forecasts as opposed
to the creditworthiness of the sponsors and the actual value of the project assets. Forecasting is
thus central to project financing techniques. Project financing, together with project sponsors'
equity, must be sufficient to cover all project development costs as well as working capital
requirements.

As a result, project finance risks are highly specific, and it is critical that participants such as
commercial bankers, investment bankers, general contractors, subcontractors, insurance
companies, suppliers, and customers understand these risks because they will all be participating
in an event.
The various participants in project financing have varying contractual obligations, and the
resulting risk and reward varies with their function and performance.

Debt servicing should ideally be supported by the project cash flow dynamics rather than the
participants, who can only provide limited coverage.

Uses for project finance

Project finance techniques have made it possible to build projects in markets using private
capital. These private finance techniques are a critical component in reducing government
spending.

There is a US Republican ideologue and lobbyist, who says 'I don't want to abolish government.
I just want it to be small enough that I can drag it into the bathroom and drown it in the bathtub.
The macroeconomic policies that feed project finance are made on the basis of such ideological
agendas and lobbyist machinations, transferring control of public services from the electorate to
private, unaccountable, and uncoordinated interests.

Project financing is a key method of utilizing private capital to achieve private ownership of
public services such as energy, transportation, and other infrastructure development initiatives
under such agendas. The ultimate goal is to render government irrelevant and to achieve a two-
tier society in which government caters for the marginalized while infrastructure development
and exploitation are delegated to private capital, free of government oversight.

Among the industries financed are:

■ Energy Project finance is used to build energy infrastructure in industrialized countries as well
as in emerging markets.
■ Oil Development of new pipelines and refineries are also successful uses of project finance.
Large natural gas pipelines and oil refineries. Before the use of project finance, such facilities
were financed either by the internal cash generation of oil companies, or by governments.

■ Mining Projects; Project finance is used to develop the exploitation of natural resources such
as copper, iron ore, or gold mining operations in countries as diverse as Chile, Ghana and
Australia.

■ Highways and New roads are often financed with project finance techniques since they lend
themselves to the cash flow based model of repayment.

■ Telecommunications. The burgeoning demand for telecommunications and data transfer via
the Internet in developed and developing countries necessitates the use of project finance
techniques to fund this infrastructure development.

■ Other sectors targeted for a private takeover of public utilities and services via project finance
mechanisms include pulp and paper projects, chemical facilities, manufacturing, hospitals,
retirement care facilities, prisons, schools, airports and ocean-going vessels.

Advantages of project finance

■ Non-recourse/limited recourse financing

Non-recourse project financing imposes no obligation on the project sponsor to guarantee the
repayment of the project debt. This is significant because, due to capital adequacy requirements
and credit ratings, accepting financial commitments to a large project may have a negative
impact on the company's financial structure and credit rating (and ability to access capital).

Non-recourse project financing

Non-recourse project financing means that debts cannot be repaid using the project sponsor's
assets or the liabilities of a single project. Non-recourse financing is thus based solely on a
project's merits rather than the creditworthiness of the project sponsor. Credit appraisal is thus
based on the project's expected cash flows and is unrelated to the creditworthiness of the project
sponsors. In such a case, the project sponsor is under no direct legal obligation to repay the
project debt or pay interest.

Limited recourse project finance

In most project financings, the project sponsor has limited obligations and responsibilities; that
is, the financing is limited recourse. Security, for example, may not be available sufficient to
ensure a project's success. The main issue here is not that the guarantees offered fully mitigate
the project, but rather that they involve the sponsor's involvement sufficiently deeply to fully
incentivize the sponsor to ensure the project's technical success.

The amount of recourse required to support a financing is determined by the project's unique
characteristics. The project risks and the level of support provided by the sponsors will have a
direct impact on the project's risk profile and syndication strategy.

Leveraged debt

Debt is advantageous for project finance sponsors because it allows them to avoid share issues
(and equity dilution). Furthermore, the equity requirements for projects in developing countries
are influenced by a variety of factors, including the country, the project, and the project's
location. The economics of the project, whether other project participants invest equity in the
project, and the eagerness of banks to win the project finance business.
Avoidance of restrictive covenants in other transaction

Existing restrictive covenants do not typically apply because the financed project is distinct from
the sponsor's other operations and projects. A project finance structure allows a project sponsor
to avoid restrictive covenants in existing loan agreements and indentures, such as debt coverage
ratios and provisions that cross-default for debt failure.

Favourable tax treatment

Tax efficiency is frequently a driving factor in project financing. Tax breaks and allowances for
capital investments, for example, can encourage the use of project finance. These tax credits may
be used by projects that contract to provide a service to a state entity Breaks (or subsidies) are
provided to increase the profitability of such ventures.

Favourable financing terms

Project financing structures can improve the credit risk profile and thus obtain better pricing than
the project sponsor's credit risk profile alone.

Political risk diversification

Creating SPVs (special purpose vehicles) for projects in specific countries quarantines the risks
of the project and protects the sponsor (or the sponsor's other projects) from liability.

Risk sharing

Risk allocation in a project finance structure allows the sponsor to spread risks across all project
participants, including the lender. The spread of risk can improve project feasibility.
A summary of project financing

For project success, each project participant accepts certain risks. However, the multiplicity of
participating entities can result in increased costs that must be borne by the sponsor and passed
on to the end consumer, who are frequently consumers who would be better served by public
services.

Collateral limited to project assets

Non-recourse project finance loans are predicted on the assumption that collateral will only come
from project assets. While this is generally true, the assets have limited recourse.

The project sponsor's approval is sometimes required as a means of incentivizing the sponsor.

Lenders are more likely to participate in a workout than foreclose

Because project finance is non-recourse or limited recourse, collateral (a half-completed factory)

has limited value in a liquidation scenario. As a result, if the project is experiencing difficulties,
finding a workable solution rather than foreclosing offers the best chance of success. As a result,
lenders are more likely to cooperate in a workout scenario in order to minimize losses. Lenders
are more likely to work out than to foreclose.

Disadvantages of project finance

Complexity of risk allocation

Project financings are complex transactions involving a large number of participants with
varying interests. This leads to participant conflicts of interest in risk allocation, as well as
protracted negotiations and increased costs to compensate third parties.

Increased lender risk

Because banks do not take equity risks, the options for reducing credit risk to acceptable levels
are limited, resulting in higher prices. This necessitates costly processes as well. Due diligence
performed by attorneys, engineers, and other specialized consultants

Higher interest rates and fees

Because the transaction structure is complex and the loan documentation is extensive, interest
rates on project financings may be higher than on direct loans made to the project sponsor.
Lengthy Project finance is generally more expensive than traditional lending because of the
following factors: the time spent by lenders, technical experts, and lawyers evaluating the project
and drafting complex loan documentation; the increased insurance cover, particularly political
risk cover;

Lender supervision

To protect themselves, lenders will want to closely monitor the project's management and
operations (while avoiding any liability associated with excessive risk). This supervision
includes site visits by the lender's engineers and consultants, construction reviews, monitoring
construction progress and technical performance and financial covenants to ensure funds are not
diverted from the project. The purpose of this lender supervision is to ensure that the project
proceeds as planned, because the primary value of the project is cash flow generated by
successful operation.

Lender reporting requirements

Lenders will expect the project company to provide a consistent stream of financial and technical
information so that they can track the project's progress. Financial statements, interim statements,
reports on technical progress, delays, and corrective measures, and other forms of reporting are
included notices such as default events

Increased insurance coverage

Because project finance is non-recourse, risks must be mitigated. Some of this risk can be
mitigated by commercially available insurance rates. This, however, can significantly increase
costs, which raises other risks such as pricing and successful syndication.

Transaction costs may outweigh the benefits

The complexity of the project financing arrangement may result in a transaction with costs that
outweigh the benefits of the project financing structure. Time-consuming negotiations between
various parties and government bodies, restrictive covenants, and limited control of project
assets, and rising legal costs may all conspire to make the transaction unfeasible.

LESSON TWO

DESCRIPTION OF A TYPICAL PROJECT FINANCE TRANSACTION

Project finance transactions are complex, requiring multiple players in interdependent

relationships. As an example, we provide an Overview of Project Finance Associations of
corporate clients, Board of Directors for Government Relations, Public relations, External legal
counsel, Credit Officer in charge of finances, World Bank policies, Technical assistance Bank,
Commercial Finance Committee, Board Syndications of Senior Management. Other lenders
include Pension plans Companies that provide insurance, Investing in mutual funds Loans,
Syndications and the secondary market Deposits.
-The project company, which is a special purpose vehicle (SPV) made up of consortium
shareholders (such as contractors or operators who may be investors or have other interests in the
project), is typically at the heart of project financing. The SPV is created specifically for this
purpose toConstruct and run the project. The SPV can be set up as a local project company or as
a consortium of joint ventures (JVs).

The SPV is formed as an independent legal entity that enters into contractual agreements with a
number of other project parties. Contracts serve as the foundation for project viability and exert
control.The project company enters into negotiations with the host government to obtain all
requisite permits and authorizations, e.g. an oil or gas production licence, a mining concession,
or a permit to build and operate a power plant.

■ A syndicate of banks may enter into a financial agreement to finance the project company.
There may be several classes of lending banks, e.g.

■ International banks lending foreign currency;

■ Local banks lending domestic currency for local costs;

■ export credit agencies lending or guaranteeing credits to finance suppliers to the project of
their national equipment.

■ International agencies lending or guaranteeing development credits include; World Bank,

Asian Development Bank, African Development Bank, European Bank for Reconstruction and
Development).

■ The project company enters into various contracts necessary to construct and operate the
project: The major types of contracts include:

■ EPC contract (engineering, procurement and construction) – to build and construct the project
facility;
■ O&M contract (operation and management) – to manage and operate the facility and project
during its operational phase

; ■ supply contract (the project company enters into contracts with suppliers to ensure an
uninterrupted supply of raw materials necessary for the project);

■ off-take agreements (the project company enters into contracts with purchasers of the project
company’s product or service).

Project phases

Construction and development phase

The loan will be extended, and debt service may be delayed, either through rolling up interest or
by allowing additional drawdowns to finance interest payments prior to the operation phase. The
building phase is when the Lenders face the greatest risk during this period because resources are
being committed and construction must be completed before cash flow can be generated. To
compensate for the increased risks, margins may be higher than in other phases of the project.
The risks will be reduced by securing the construction contract and related performance bonds.

Operation phase

Because the project will begin to generate cash flows, the lenders will have additional security.
Debt service is typically tailored to the project's actual cash flows - typically, a dedicated
percentage' of net cash flows will be paid back via security. Structures such as blocked accounts
are automatically transferred to lenders, with the remainder transferred to the project company.
The loan terms will frequently include provisions for alternative arrangements if cash flows
generate an excess or shortfall due to unanticipated economic or political risks.
LESSON THREE

EVALAUATING A PROJECT

The offering memorandum

The agent bank, in collaboration with the project sponsors, will prepare an offering
memorandum (also known as an information memorandum) as the first step in the syndications
sales cycle. This occurs during the initial stages of the loan.

Most potential syndicated loan participants are expected to exercise prudent credit judgment by
conducting their own credit analysis. we simply note that there is a standard approach to
assessing lending risks that typically includes obtaining information such as certificates of
incorporation, authorized signatories, annual reports, auditor's certificates, and so on. There are
elements in any project finance transaction that are outside the scope of traditional frameworks
and checklists. This is especially true in transactions of a one-of-a-kind nature, such as aircraft
leasing or project financing.The purpose of the memorandum is to explain the project potential to
lenders, including topics such as project sponsors' experience, the identity and experience of
project participants (contractor, operator, suppliers, and off-take purchasers); information on the
host government; project contract summaries, project risks and how they are addressed; proposed
financing terms; the construction budget, financial projections; and financial information about
the project sponsors and other project participants.

The memorandum's purpose is to sell the loan - to help 'the participating banks reach a credit
decision, especially small banks that do not have seasoned credit analysts.
■ Disclaimer: It is important that it be clearly and prominently displayed.

■ Authority letter: Here the borrower authorizes release of the information memorandum to the
syndicate.

■ Project overview: A brief description of the proposed project is included first in the
memorandum. The overview includes the type of project, background on the host country, the
status of development and other significant information.

■ Borrower: The description of the borrower explains the form of organization (corporation, pa

rtnership, limited liability company) and place of organization of the borrower. It includes the
ownership structure of the borrower.

■ Project sponsors: The identity, role and involvement of the project sponsors in the project is
included. Summary financial information about the sponsors is also given. This section also
specifies the management structure of the project company.

■ Debt amount/uses of proceeds: How much debt the project will need is described generally in
this section. Also included is the currency in which the loan is to be made and repaid. The
manner in which loan proceeds will be used is an important part of the memorandum.

■ Sources of debt and equity: The total construction budget and working capital needs of the
project, including start-up pre-operation costs, are outlined in this section. Also, the sources of
the funds needed for the project are explained, including debt and equity.

■ Collateral: This discussion includes the identity of collateral, whether the collateral is junior
in lien priority to other debt, and any special collateral considerations.

■ Equity terms: The terms of the equity are more completely described in this section. Included
are explanations of the type of equity investments; 86 Introduction to Project Finance when the
equity will be contributed; how the equity will be funded, whether the commitment is absolute or
subject to conditions, and if conditional, why it is conditional.

■ Cost overruns: The offering memorandum may set forth an explanation of how any cost
overruns will be funded.
■ Sponsor guarantee/credit enhancement: Any other guarantees or credit enhancement that
the project sponsors will provide are also described.

■ Debt amortization: This section describes the proposed debt repayment terms, including
amortization schedules and dates for repayment of interest and principal. Mechanical elements
such as minimum amounts of prepayments, advance notice of prepayments, may also be
described (but are governed by the loan agreement).

■ Commitment drawdown and cancellation of commitment:The mechanical provisions are

typically included, although they are generally identical boilerplate clauses in standard loan
contracts. These include minimum drawdown amounts, and timing and notice of drawdowns.

■ Interest rate: Typical interest rate options include a bank’s prime (or reference) rate, being the
rate typically offered to its best customers, LIBOR (London Interbank Offered Rate), Cayman
(rates of banks with respect to Cayman Island branches), and HIBOR (Hong Kong Interbank
Offered Rate). Rates can, of course, also be fixed.

■ Fees: The fees offered to the lenders, including structuring fees, closing fees, underwriting
fees and commitment fees, are described. Amounts are usually left blank and resolved during
negotiations.

■ Governing law: In this section the choice of law to govern the loan documents is listed. It is
sometimes the law of the host country. However, that is not so in financings in developing
countries, unless lenders in the host country provide all debt.

■ Lawyers, advisers and consultants: This section will identify the lawyers, advisers and
consultants involved in the project; often a budget for legal fees is requested.
 Information memorandum issues

The information memorandum's purpose is to sell the deal to other banks by selectively
providing technical, economic, contractual, governmental, and market information on the
proposed project.

The project sponsor uses this report to generate interest from potential lenders, government
officials, and equity investors.

To maximize the potential for generating interest, different reports may be prepared for each of
these audiences, just as different CVs are prepared for different employers. These information
memos effectively pre-prepare the analytical grunt work for potential capital providers. The
information memorandum will be divided into several sections.

(1) Detailed description

(2) General description

The feasibility study usually starts with an overview of the project. The location is specified,
which usually includes a map of the project site and any other ancillary details that anyone may
require.

Topography, weather, drainage, major landmarks, population density, access to transportation

and housing, water and wastewater treatment facilities, and other data are all covered. Data that
threatens to obfuscate the analysis is conveniently ignored so as not to interfere with the
transaction's marketing.
■ Project sponsors and project company

The ownership interests in the project company, as well as management control, are specified in
great detail. This includes the standard corporate-produced background prose and the project
sponsors' experience. The feasibility study will be selective in quoting various successful
previous projects. This marketing exercise makes no mention of previous embarrassments; the
goal is to impress potential investors with the project sponsors' vast and omniscient experience,
as well as their impeccable track record.

■ Project participants

Participants such as the contractor, operator, fuel supplier, offtake purchaser, local and central
governments, and so on are obviously praised. Furthermore, participants are linked to previous
projects, emphasizing anything positive and ostensibly relevant. Biographies, financial data, and
credit information

The report includes ratings and anything else that is likely to impress investors. To the extent that
detailed financial information about the participants is available, such as securities filings, this
information is included, but no analytical judgements are offered because doing so could be
interpreted as a recommendation to participate, which could be an awkward accusation to deal
with if the deal encounters difficulties.
Technical information

The feasibility study's technical information section provides an overview description of the
proposed project as well as an explanation of the technology and processes that will be used.

Because banks save money by hiring analysts, this technical information is useful in the sense
that it is intended to impress through volume and depth rather than provide practical information
for a decision. Furthermore, because most bankers are incapable of comprehending this technical
information, the exercise is primarily intended to reassure bank officers and credit committees,
as well as to satisfy legal requirements that the transaction was properly analyzed. As a result,
the more comprehensive and complete the information, the more impressive. The fact that much
of this information may lack a direct cause and effect relationship is irrelevant because the entire
exercise is intended to impress.

■ Economic information

Despite the fact that economists and governments cannot plan economic policy because they are
usually at the service of ideologues, bankers want economic data in the feasibility study, so it is
included. Economic information explanations for the proposed project's construction, operating,
and financing expenses, as well as an estimate of the project's investment return.

The most important thing is to develop a forecast that can be approved by a credit committee in
order to close the deal.

■ Contracts

An analysis of the documentation and credit enhancement structure will be included in the
information memorandum. Any differences in the legal framework of the host country will be
noted, typically through expert legal opinions. Development agreements, partnership agreements,
and joint venture agreements are examples of agreements.
the project management contract; the construction contract; the operating agreement; any site
leases or other real estate contracts; fuel and raw material supply agreements; output sale
agreements; waste disposal agreements; host country agreements; and so on. Aside from general
information about these contracts, each description typically includes negotiation schedules,
details on current negotiations, major issues that have not yet been resolved, and other similar
information.

Project schedule

The timetable for the project's development, construction, and initial operation should be
included, with all important milestones noted. This includes obtaining necessary government
permits and approvals.

■ Government

The study describes the host government and provides information on the likelihood of its
support for the project.

Because of the unpleasant realities, this is frequently a pointless PR exercise.

Rigged elections, media censorship, torture, cronyism, or corrupt government officials siphoning
off funds from similar projects into overseas bank accounts or requesting cash commissions will
be avoided because they would offend the relevant government and be counterproductive to the
project's introduction to project finance. As a result, such analysis is typically bland, inoffensive,
and uninformative, and is included for the sake of formality rather than any meaningful analysis.
As a result, it is up to the bankers to conduct their own independent research into the underlying
realities.
Access to raw materials

If the project is dependent on raw material availability, the report will address these concerns. If
a government grants a concession for the development of a mine, the project will also require
access to domestic supplies of other strategic raw materials, such as oil or gas. The government
may agree in these cases to make the raw materials available to the project at a certain price. If
critical raw material access is jeopardized, guarantees or insurance should be included wherever
possible. In cases where the government does not control access, there may be ways to facilitate
access, such as having the government waive or reduce tariffs on such items.

Investment appraisal

The net present value (NPV) method is the most commonly used method of calculating project
viability.The investment project's net present value (NPV) should be subjected to a base case
analysis.Case and sensitivity analysis are used to account for various scenarios.
LESSON 4

CONTRACTUAL FRAMEWORK

Pre-development agreements

■ Licences and concessions

In many cases, implementing a project financing in its construction and operating phases is
contingent on obtaining the necessary licenses, permits, and concessions from the government.

The government of the country where the project is based. The government may negotiate
specific clauses that allow it to revoke the license or concession. Lenders should seek security
through a variety of means, including government approval of the financing and the project, as
well as the ability for lenders to take enforceable security, manage the project if necessary, and
repatriate profits.

concession agreements

Concession agreements create the right and obligation to build, own and eventually transfer back
to the grantor infrastructure used for the general benefit of the population. Concession
agreements should therefore clearly state the rights such as terms and duration of the concession,
ability to extend the concession Contractual framework even if there are changes in the law,
termination of the concession should not be expropriatory, and banks should be able to freely
transfer the concession to a third party.
shareholder agreements

Given that the stockholders' interests differ, it is preferable to have a shareholder agreement to
govern the stockholders' relationship with respect to the project. These agreements include

Management and voting; development, construction and operating stage financing; working
capital financing and the amounts and dates of additional capitalization.

Partnership agreements

A partnership agreement governs project ownership where the project participants choose a
general or limited partnership form of ownership. The agreement forbids anything that has a
significant negative impact on the project. Such as incurring additional debt, amending or
modifying the loan agreement or important project contracts; waiving security rights, selling the
project, and so on, without the approval of a certain number of partners.

■ Ensure that the project company constructs and operates the project in the manner
contemplated in the technical and economic assumptions that are the foundation of financial
projections.

■ Provide the lender with advance or prompt warning of a potential problem, whether political,
financial, contractual or technical.

■ Protect the lender’s liens. These include covenants that the project will be constructed on
schedule, within the construction budget and at agreed-upon performance levels; be operated in
accordance with agreed standards; that project contracts will not be terminated or amended; and
comply with operating budgets approved by the lender. A JV agreement will govern the
participants' interactions and specify issues such as the JV's name and purpose, management and
voting rights, and other mechanistic aspects of the project to be defined, such as the date and
time of capital injections, transferability, sale, competition, and so on.
Construction agreements

Turnkey construction contracts are required. Nothing should 'fall between the cracks' in the
construction and design. As a result, there must be no nominated subcontractors or equipment
specified by the project company (or, if there are, the contractor must accept responsibility).

■ There should be a fixed price, incapable of being reopened, and the price should be paid in one
lump sum on completion.

■ Completion must occur within a fixed period.

■ The force majeure events should be limited.

■ Liquidated damages should be payable if completion is not achieved by a fixed date and those
liquidated damages should be adequate and at least cover interest payable on the loan. ■ There
should be no (or large) limits on the contractor’s liability. ■ The contractor should give extensive
guarantees and, if the contractor is to be released from liability for defects after a period, that
period should be long and only run from the passing of a well-defined completion test.

CONTRACTORS BONDS

Bid (or tender) bonds

These bonds require the bidder to pay a penalty if the contract is awarded to them and they
decide to withdraw.

This mechanism is intended to prevent fraudulent bids.

solely to deny competitors work

Performance bonds

These effectively guarantee the contractor's performance for a percentage (perhaps 5% or 10%)
of the contract price.

Advance payment guarantees

The project company may be required to advance funds in order for the contractors to purchase
materials and begin working on the contract. In such cases, the contractor will provide an
advance payment guarantee, which means that if they do not receive payment, they will be
reimbursed.

begin (or complete the start) working on the project, they will be required to refund the advance
granted.

Retention guarantees

The construction contract may require the project company to keep a certain percentage of the
progress payments in order to repair defects that may not be discovered right away.

apparent. In contrast, if the contractor wishes to receive full payment, he or she may instead offer
a guarantee for the amount of the retention guarantee.

Operating and maintenance agreements

Several mechanisms are used by sponsors to try to mitigate supply risk. The major provisions
sought by lenders in operating and maintenance agreements are similar to those sought by the
project company.

Sponsor support agreements

Working capital, maintenance and cash deficiency agreements

These provide comfort similar to a completion guarantee, except that they can remain in place
(maintenance) beyond the completion date.
Management agreements

The management of the project entity in some projects is governed by a separate document in
which a project manager is appointed to manage the project. Typically, the project management
agreement imposes on

Certain management conditions which must be agreed upon by the project. Typical
responsibilities include management, budgeting and forecasting, financial and technical record
keeping, reporting, construction management, and so on.

Project loan/credit agreements

Loan agreements define and govern the financing instruments and interrelationships among the
various parties involved in project financing. Loan agreements can be supplemented by an
intercreditor clause.

Agreement outlining the rights of project creditors in the event of a default.

Another function of loan documentation is to ensure that the initial credit risk profile remains
constant throughout the facility's life. This is accomplished by incorporating various loan
agreement conditions and covenants that define what management can and cannot do.

Loan agreements can also use financial or ratio covenants to bind the borrower to certain
parameters such as liquidity, cash flow, and other elements that may negatively impact the
borrower's (and project's) risk profile.

Project financing covenants

Covenants in a project finance transaction are more complicated than those in a standard
syndicated loan due to the complexity of project finance. They must account for all possible
outcomes.

Many of the covenants required by lenders in asset-based loan transactions are included in a
project finance loan agreement.
Project finance loan documents, on the other hand, differ from asset-based transactions.

are intended to closely monitor and regulate the project company's activities. As a result, the
covenants may be of a bespoke nature, the variety of which is only limited by the characteristics
of the project being financed. Some of these are listed below.

■ Ensure that the project company constructs and operates the project in the manner
contemplated in the technical and economic assumptions that are the foundation of financial
projections.

■ Provide the lender with advance or prompt warning of a potential problem, whether political,
financial, contractual or technical.

■ Protect the lender’s liens. These include covenants that the project will be constructed on
schedule, within the construction budget and at agreed-upon performance levels; be operated in
accordance with agreed standards; that project contracts will not be terminated or amended; and
comply with operating budgets approved by the lender.

LESSON FIVE

TOOL OF PROJECT FINANCE

Tools of project financing: Ratio analysis of financial statements, time value of money, valuation
of assets shareholders equity. Introduction Project managers use tools to analyze, forecasts,
budgets, income statements and other financial documents. To maximize the profitability and
return on investment for projects, a project manager requires a working knowledge of basic
finance and accounting concepts such as ratio analysis of financial statements, time value of
money, and valuation of assets shareholders equity to manage reports to ensure a project runs
smoothly.. Ratio analysis of financial statements Ratio analysis involves the construction of
ratios using specific elements from the financial statements in ways that help identify the
strengths and weaknesses of the firm. Using ratios often provides a standardized measure which
is easier to interpret. For example, suppose you go to the supermarket to buy a box of cereal.
You see a 100 gms box sells for 320 and a larger 150gms box sells for 450. Which would you
buy? You can look at the price of each box and the amount contained in each box but it is
difficult to tell which is the better deal because the more expensive box also contains more
cereal. If we divide the price of each box, however, by the amount of cereal in the box we see
that the small box cost 320/100. = Kshs 3.2 per gm and the large box cost 450/150 = Kshs 3per
gm. The large box of cereal costs you less for each gm of cereal you purchase. This illustrates the
power that ratios can have in helping analyze sets of data such as those we encounter in a firm’s
financial statements. Types of Ratio a) Liquidity ratios Liquidity ratios measure a firm’s ability
to meet its maturing financial obligations. The focus is on short-term solvency as if the firm were
liquidated today at book value. The current ratio (CR) is the most common liquidity measure and
provides an indication of a firm’s ability to pay short-term claims with short-term assets. We
define the current ratio as: CR = CA / CL where CR is current ratio, CA is current assets, and CL
is current liabilities. In principal we would like to see the CR > 1 because it suggests that the CA
to be liquidated this year are sufficient to cover the CL that will come due this year. If the CR <
1, then the CA will be unable to service the maturing obligations as measured by CL. b)
Profitability Ratios: Profitability ratios measure the firm’s efficiency in generating profits.
Remember the operating profit is measured by the firm’s EBIT and profit-after-tax is measured
by NIAT. Profit margin on sales measures the proportion of each dollar of sales that is retained
as profit after taxes and is defined as: m = NIAT Sales where m represents the profit margin
Advantages • Ratios help measure the relative performance of different financial measures that
characterize the firm’s financial health. Time value for Money The time value of money (TVM)
is the concept that money available at the present time is worth more than the identical sum in
the future due to its potential earning capacity. This core principle of finance holds that, provided
money can earn interest, any amount ofmoney is worth more the sooner it is received. The
principle of the time value of money explains why interest is paid or earned: Interest, whether it
is on a bank deposit or debt, compensates the depositor or lender for the time value of money. It
also underlies investment. Investors are willing to forgo spending their money now if they expect
a favorable return on their investment in the future.

CASH FLOW STATEMENT

In financial accounting, a cash flow statement, also known as statement of cash flows, is a
financial statement that shows how changes in balance sheet accounts and income affect cash
and cash equivalents, and breaks the analysis down to operating, investing and financing
activities. People and groups interested in cash flow statements include: • Accounting personnel,
who need to know whether the organization will be able to cover payroll and other immediate
expenses • Potential lenders or creditors, who want a clear picture of a company's ability to repay
• Potential investors, who need to judge whether the company is financially sound • Potential
employees or contractors, who need to know whether the company will be able to afford
compensation • Shareholders of the business.

PURPOSE OF FINANCIAL STATEMENT

The cash flow statement is intended to

1. provide information on a firm's liquidity and solvency and its ability to change cash flows in
future circumstances

2. provide additional information for evaluating changes in assets, liabilities and equity

3. improve the comparability of different firms' operating performance by eliminating the effects
of different accounting methods

4. indicate the amount, timing and probability of future cash flows The cash flow statement has
been adopted as a standard financial statement because it eliminates allocations, which might be
derived from different accounting methods, such as various timeframes for depreciating fixed
assets.

Cash flow activities

The cash flow statement is partitioned into three segments, namely:

1. cash flow resulting from operating activities;

2. cash flow resulting from investing activities;

3. cash flow resulting from financing activities.

The money coming into the business is called cash inflow, and money going out from the
business is called cash outflow. 1. Operating activities Operating activities include the
production, sales and delivery of the company's product as well as collecting payment from its
customers. This could include purchasing raw materials, building inventory, advertising, and
shipping the product. operating cash flows include

• Receipts for the sale of loans, debt or equity instruments in a trading portfolio • Interest
received on loans

• Payments to suppliers for goods and services • Payments to employees or on behalf of

employees

• Interest payments (alternatively, this can be reported under financing activities in IAS 7)

• buying Merchandise Items which are added back to [or subtracted from, as appropriate] the net
income figure (which is found on the Income Statement) to arrive at cash flows from operations
generally include:

• Depreciation (loss of tangible asset value over time)

• Deferred tax

• Amortization (loss of intangible asset value over time)

• Any gains or losses associated with the sale of a non-current asset, because associated cash
flows do not belong in the operating section (unrealized gains/losses are also added back from
the income statement).

• Dividends received •

2. Investing activities Examples of Investing activities are

• Purchase or Sale of an asset (assets can be land, building, equipment, marketable securities,
etc.)

• Loans made to suppliers or received from customers • Payments related to mergers and
acquisition.

3. Financing activities

Financing activities include the inflow of cash from investors such as banks and shareholders, as
well as the outflow of cash to shareholders as dividends as the company generates income. Other
activities which impact the long-term liabilities and equity of the company are also listed in the
financing activities section of the cash flow statement.

• Payments of dividends

• Payments for repurchase of company shares

• For non-profit organizations, receipts of donor-restricted cash that is limited to long-term

purposes Items under the financing activities section include:

• Dividends paid

• Sale or repurchase of the company's stock

• Net borrowings

• Repayment of debt principal, including capital leases Disclosure of non-cash activities non-
cash activities may be disclosed in a footnote or within the cash flow statement itself

. Non-cash financing activities may include

• Leasing to purchase an asset

• Converting debt to equity

• Exchanging non-cash assets or liabilities for other non-cash assets or liabilities

• Issuing share

• Payment of dividend taxes in exchange for assets