Financing - Source of Financing - Project Financing

Question 1

How is project financing set up

Answer 1

• The lender usually won’t want to be exposed to the entire risk of a project and will want some equity investment to also

Question 2

Explain what is project financing

Answer 2

• A special form of long-term financing that is used for the construction and development of large infrastructure and industrial projects
  -Size, complexity, and time to construct, these projects require a large amount of capital, and this capital is often raised from multiple sources

Question 3

How does equity contribution dictate project financing

Answer 3

If a company does not have enough funds for the project, it can acquire financing using a sponsor
Ex. Project requires 100 million, stipulate 15% of the amount must the contributed equity capital. Equity 85%
- Ownership in project, entity will be 33%(5/15) ownership and other sponsor 67%(10/15)

Question 4

Explain how debt financing is used for project financing

Answer 4

• It is used after the equity contribution of the amount needed for the project.
• Known as non-recourse loan - Lender seizes specific project assets as security for the loan
  Draws - mitigate the lender exposure to losses, project encounters difficulties, limited to the amount advanced up.

Question 5

What are the two types of debt

Answer 5

1. Senior debt - has seniority over all other sources of debt in the event of default
2. Mezzanine debt - a special type of debt that has priority over equity but is subordinate to other debt (more riskier)

Question 6

Provide the 5 types of contractual arrangement

Answer 6

1. Completion & quality assurance arrangement - The project will be completed on time and meet specification or quality test
   Completion risk - related to technical failure, cost overriding, inability to raise
   Technological risk - Relates to the possibility that the project does not meet the performance requirement
2. Raw material supply -
   Is the risk that raw materials become depleted or unavailable during the life of the project and that other sources
3. Output or service arrangement
   - Are made when the sponsor is the primary customer of the project or are output/ service
   - The amount of guarantee might be determined by the cash flow required to service
4. Completion, quality assurance & purchase arrangement
   - Provide a guarantee against the key risk associated with the project
   - Agreement may also include terms covering types of risk beyond the control
5. Cash flow guarantee arrangement
   - Sponsor effectively guarantees project against default
   - One or more sponsors cover the deficiency in cash flow

Question 7

What are the 4 advantages of project financing for the sponsor

Answer 7

1. The sponsor can share the benefits of some projects and risk
2. Sponsors do not have to use their debt capacity allowing them to retain the project
3. Can share business & financial risks in some project financing arrangement

Question 8

What are four disadvantages of project financing for the sponsor

Answer 8

1. Arrangement is often complex and results in substantial fees to lawyers and investment banker
2. Project financing sometimes guarantees from financial institutional
3. Any profits earned by the project must be first used to pay down the debt before the sponsor can withdraw funds for their own use
4. Entity requires additional sponsor to provide additional sponsor equity financing, profit must be shared

Question 9

What discount rate is used to calculate the risk of the project

Answer 9

• incremental cash flow related to the project are discounted by company WACC

Adjusting discount rate for project financial leverage
1. Determine the unleveled equity beta for the project
2. Use this calculated levered equity beta to determine the project cost of equity
3. Calculate the project WACC with all the new inputs

Question 10

What is the formula to use to calculate the discount rate

Answer 10

Step 1 BE = Bu + D/E (Bu - Bd) (1-T)

D= market value of debt
E = Market value of equity
Be = Levered project beta
T= corporate tax rate
Bu = unlevered project beta
Bd= beta of project debt

Step 2- Calculate the project cost of equity under the project capital structure
Cost of equity = risk free return (Rf) + Beta (B) * Market risk premium

Step 3 - Calculate WACC
D/V * Rd(1-T) + P/V * Rp + E/V *Re