Project finance is typically defined as limited or non-recourse financing of a new project through separate incorporation of vehicle or Project Company. Project financing involves non-recourse financing of the development and construction of a particular project in which the lender looks principally to the revenues expected to be generated by the project for the repayment of
its loan and to the assets of the project as collateral for its loan rather than to the general credit of the project sponsor. In other words the lenders finance the project looking at the creditworthiness of the project, not the creditworthiness of the borrowing party. Project Financing discipline includes understanding the rationale for project financing, how to prepare the financial plan, assess the risk, design the financing mix, and raise the funds.
A knowledge base is required regarding the design of contractual arrangements to support project financing; issues fior the host government legislative provisions, public/private infrastructure partnerships, public/private financing structures; credit requirements of lenders, and how to determine the projects borrowing capacity; how to prepare cash flow projections and use them to measure expected rates of return; tax and accounting considerations; and analytical techniques to validate the projects feasibility. Comparison between Corporate finance and Project finance
Traditional finance is corporate finance, where the primary source of repayment for investor and creditors is the sponsoring company, backed by its entire balance sheet, not the project alone. Although creditors will usually still seek to assure themselves of economic viability of the project being financed so that it is not a drain on the corporate sponsors existing pool of assets, an important influence on their credit decision is the overall strength of the sponsors balance sheet, as well as their business reputation.
If the project fails, lenders do not necessarily suffer, as long as the company owning the project remains financially viable. Corporate finance is often used for shorter, less capital-intensive projects that do not warrant outside financing. The company borrows funds to construct a new facility and guarantees to repay the lenders from its available operating income and its base of assets. However private companies avoid this option, as it strains their balance sheets and capacity, and limits their potential participation in future projects.
Project financing is different from traditional forms of finance because the financier principally looks to the assets and revenue of the project in order to secure and service the loan. In project finance, a team or consortium of private firms establishes a new project company to build, own and operate a separate infrastructure project. The new project company to build own and operate a separate infrastructure project. The new project company is capitalized with equity contributions from each of the sponsors.
In contrast to an ordinary borrowing situation, in a project financing the financier usually has little or no recourse to the non-project assets of the borrower or the sponsors of the project. The project is not reflected in the sponsors’ balance sheets. Extent of recourse Recourse refers to the right to claim a refund from another party, which has handled a bill at an earlier stage. The extent of recourse refers to the range of reliance on sponsors and other project participants for enhancement to protect against certain projects risks. In project financing there is limited or no recourse.
Non-recourse project finance is an arrangement under which investors and credit financing the project do not have any direct recourse to the sponsors. In other words, the lender is not permitted to request repayment from the parent company if borrower fails to meet its payment obligation. Although creditors security will include the assets being financed, lenders rely on the operating cash flow generated from those assets for repayment. When the project has assured cash flows in the form of a reliable off taker and well-allocated construction and operating risks, the lenders are comfortable with non-recourse financing.
Lenders prefer limited recourse when the project has significantly higher risks. Limited recourse project finance permits creditors and investors some recourse to the sponsors. This frequently takes the form of a precompletion guarantee during a projects construction period, or other assurance of some form of support for the project. In most developing market projects and in other projects with significant construction risk, project finance is generally of the limited recourse type.
Scope and Importance of Project Finance: Whether expanding manufacturing facilities, implementing new processing capabilities, or leveraging existing assets in new markets, innovative financing is often at the core of long-term projects to transform a company’s operations. Akin to the underlying corporate transformation, the challenge with innovative financial structures such as project finance is that the investment is made upfront while the anticipated benefits of the initiative are realized years later.
There has been a rise in number of companies that need innovative financing to satisfy their capital needs, in a significant number of instances they have viable goals but find that traditional lenders are unable to understand their initiatives. And so the need emerged for project finance. Project financing is a specialized form of financing that may offer some cost advantages when very large amounts of capital are involved It can be tricky to structure, and is usually limited to projects where a good cash flow is anticipated.
Project finance can be defined as: financing of an industrial (or infrastructure) project with myriad capital needs, usually based on non-recourse or limited recourse structures, where project debt and equity (and potentially leases) used to finance the project are paid back from the cash flow generated by the project, with the project’s assets, rights and interests held as collateral. In other words, it’s an incredibly flexible and comprehensive financing solution that demands a long-term lending approach not typical in today’s market place.
Whether expanding manufacturing facilities, implementing new processing capabilities, or leveraging existing assets in new markets, innovative financing is often at the core of long-term projects to transform a company’s operations. Akin to the underlying corporate transformation, the challenge with innovative financial structures such as project finance is that the investment is made upfront while the anticipated benefits of the initiative are realized years later. Infrastructure is the backbone of any economy and the key to achieving rapid sustainable rate of economic development and competitive advantage.
Realizing its importance governments commit substantial portions of their resources for development of the infrastructure sector. As more projects emerge getting them financed will continue to require a balance between equity and debt. With infrastructure stocks and bonds being traded in the markets around the world, the traditionalist face change. A country on the crest of change is India. Unlike many developing countries India has developed judicial framework of trust laws, company laws and contract laws necessary for project finance to flourish.
Origin of Project Finance: Project financing is generally sought for infrastructure related projects. Its linkages to the economy are mutiple and complex, because it affects production and consumption directly, creates negative and positive externalities, and involves large flow of expenditure. Prior to World War I, private entrepreneurs built major infrastructure projects all over the world. During the 19th century ambitious projects such as the suez canal and the Trans-Siberian Railway were constructed, financed and owned by private companies.
However the private sector entrepreneur disappeared after world War I and as colonial powers lost control, new governments financed infrastructure projects through public sector borrowing. The state and the public utility organizations became the main clients in the commissioning of public works, which were then paid for out of general taxation. After World War II, most infrastructure projects in industrialized countries were built under the supervision of the state and were funded from the respective budgetary resources of sovereign borrowings.
This traditional approach of government in identifying needs, setting policy and procuring infrastructure was by and large followed by developing countries, with the public finance being supported by bond instruments or direct sovereign loans by such organizations as the world Bank, the Asian Development Bank and the International Monetary Fund. Development In the early 1980s ? The convergence of a number of factors by the early 1980s led to the search for alternative ways to develop and finance infrastructure projects around the world.
These factors include: ? Continued population and economic growth meant that the need for additional infrastructure- roads, power plants, and water-treatment plants-continued to grow. ? The debt crisis meant that many countries had less borrowing capacity and fewer budgetary resources to finance badly needed projects; compelling them to look to the private sector for investors for projects which in the past would have been constructed and operated in the public sector