Module 1 – Overview and Initial Phases of Project Finance

List of Questions

Q1) Define Project Finance, prerequisites and typical examples.

Q2) Characteristics of Project Finance
Q3) Generation and Screening of Project Ideas
Q4) Introduction to CIBIL score

Q1) Define Project Finance, prerequisites and typical examples.

Definition of Project Finance

Project Finance can be characterised in a variety of ways and there is no universally adopted definition but as
a financing technique,
The definition is: “the raising of finance on a Limited Recourse basis, for the purposes of developing a large
capital intensive infrastructure project, where the borrower is a special purpose vehicle and repayment of the
financing by the borrower will be dependent on the internally generated cashflows of the project”

Prerequisites of Project Finance

There are clear advantages to using Project Finance as a tool for financing large infrastructure projects.
Nevertheless, there are a number of practical pre-conditions to financing a project on a Limited Recourse
basis:

1. Sustainable economics:
Whilst comfort can be gained from (a) undertaking detailed financial due diligence and modelling to stress-
test the projected cash flows of the asset and (b) contractually mitigating revenue risk, experienced investors
and bankers will ultimately look for a clearly identifiable demand for the project’s goods or services in order to
‘rationalise the credit’

2. Identifiable risks:
An unidentified and unmitigated risk could potentially jeopardise the stability of a project. Some examples of
identifiable risks are Completion delay, Cost overrun, Sponsor credit risk, Currency & inflation etc.

3. Accessible financing:
From both Sponsor and (if applicable) Procurer perspectives, high leverage and long-tenor financing is a de
facto requirement to achieving attractive economics for large infrastructure financings

4. Political stability:
Even if political ‘force majeure’ risk is contractually born by the government (as is common practise in many
PPP programs), the efficacy of that remedy to Lenders/investors would be negated by a strategic sovereign
default – expropriation/nationalisation of assets being one potential example. Whilst such risks cannot be
mitigated against in the insurance markets, varying degrees of political risk insurance can be obtained through
the use of financing products available from multilateral and export credit agencies If the pre-conditions
above are satisfied, there is good chance that a project financing for an infrastructure asset is achievable
Examples of Project Finance
The following projects are suitable for project finance:

1. Energy (like power transmission and power generation)

2. Public infrastructure (metro rail, airport, and roads)
3. Manufacturing
4. Construction
5. Telecommunication
6. Education, and
7. Healthcare

Q2) Characteristics of Project Finance

1. Non-Recourse Financing
Non-recourse financing is a characteristic of project financing that limits the lenders’ recourse in case of
default to the assets and cash flow generated by the project, not the borrower’s other assets. This means that
if the borrower defaults on the loan, the lender can only seize the assets and cash flow generated by the
project to recover the outstanding debt.

2. Project based Financing

Project-based financing is a type of financing where lenders provide funding for a specific project, and the
project’s assets and cash flow serve as collateral for the loan. The financing is secured solely by the project’s
revenue-generating assets, such as equipment, buildings, or infrastructure, and the project’s future cash flows

3. Long-Term Financing
Long-term financing is a type of financing where borrowers receive funding for an extended period, typically
exceeding three years. It is commonly used to finance large-scale projects or capital expenditures that require
a significant upfront investment, such as infrastructure development or real estate projects. The funding is
usually provided by institutional investors, banks, or other financial institutions

4. Customized Financing
Customized financing is a type of financing that is tailored to meet the specific needs of a borrower. It can
take many forms, including term loans, lines of credit, leases, or other financial products. Customized
financing allows lenders to work closely with borrowers to structure financing solutions that fit their unique
requirements.

5. Risk Mitigation
Risk mitigation is the process of identifying, assessing, and reducing or eliminating the potential risks
associated with a particular project or financing transaction. In project financing, risk mitigation is essential to
ensure the success of the project and protect the interests of lenders and investors.

6. Large-scale projects
Large-scale projects are often complex and require significant amounts of capital to finance. These projects
can take many forms, including infrastructure projects such as airports, highways, and power plants, as well as
real estate development projects, such as commercial buildings or residential complexes.

7. Experienced Lenders
Experienced lenders play a crucial role in project financing, particularly for complex and high-risk projects.
These lenders have the expertise and resources to assess the creditworthiness of borrowers and mitigate risks
associated with project financing. Experienced lenders can be financial institutions such as banks, private
equity firms, or specialized project finance companies.
Q3) Generation and Screening of Project Ideas

Generation and Screening of a project idea begins when someone with specialized knowledge or expertise or
some other competence feels that he can offer a product or service

♦Which can cater to a presently unmet need and demand

♦To serve a market where demand exceeds supply

♦Which can effectively compete with similar products or services due to its better quality/price etc.

An organization has to identify investment opportunities which are feasible and promising before taking a full-
fledged project analysis to know which projects merit further examination and appraisal.

Generation and Screening of a project idea involves the following tasks:-

(1) Generation of ideas

A panel is formed for the purpose of identifying investment opportunities. It involves the following tasks
which must be carried out in order to come up with a creative idea –

(a) SWOT analysis – Identifying opportunities that can be profitably exploited

(b) Determination of objectives – Setting up operational objectives like cost reduction, productivity
improvement, increase in capacity utilization, improvement in contribution margin

(c) Creating Good environment – A good organizational atmosphere motivates employees to be more creative
and encourages techniques like brainstorming, group discussion etc. which results in development of creative
and innovative ideas

(2) Monitoring the Environment

An Organization should systematically monitor the environment and assess its competitive abilities in order
to profitably exploit opportunities present in the environment.

The key sectors of the environment that are to be studied are :-

(a) Economic Sector – It includes, State of economy, Overall rate of Growth, Growth of primary, secondary and
tertiary sectors, Inflation rate, Linkage with world economy, BOP situation, Trade Surplus/Deficit.

(b) Government Sector – It includes, Industrial policy, Government programmes and projects, Tax framework,
Subsidies, incentives, concessions, Import and export policies, Financing norms.

(c) Technological Sector – It includes, State of technology, Emergence of new technology, Receptiveness of the
industry, Access to technical know how.

(d) Socio-demographic sector – It Includes, Population trends, Income distribution, Educational profile,
Employment of women, Attitude towards consumption and investment.

(e) Competition Sector – It includes, No. of firms and their market share, Degree of homogeneity and
production differentiation, Entry barriers, Marketing policies and prices, Comparison with substitutes in terms
of quality/price/appeal etc.

(f) Supplier Sector – Availability and cost of raw material, energy and money
(3) Corporate Appraisal
It involves identification of corporate strengths and weaknesses.

The important aspects that are to be considered are:-

(a) Market and Distribution – Market Image, Market share, Marketing and Distribution cost, Product line,
Distribution Network, Customer loyalty

(b) Production and Operations – Condition and capacity of plant and machinery, Availability of raw materials
and power, Degree of vertical integration, Location advantage, Cost structure – Fixed and Variable costs

(c) Research and Development – Research capabilities of a firm, Track record of new product developments,
Laboratories and testing facilities, Coordination between research and other departments of the organization

(d) Corporate Resources and Personnel – Corporate Image, Clout with government and regulatory agencies,
Dynamism of top management, Competence and commitment of employees, State of industrial relations

(e) Finance and Accounting – Financial leverage and borrowing capacity, Cost of capital, Tax situation,
Relations with shareholders and creditors, Accounting and control system, Cash flows and liquidity

(4) Looking for Project Ideas

Various sources to look for good project ideas include:-

i. Trade fairs and exhibitions

ii. Studying Government plans and guidelines
iii. Suggestion of financial institutions and development agencies
iv. Investigating local materials and resources
v. Analyzing performance of existing industries
vi. Analyzing social and economic trends
vii. Analyzing new technological developments
viii. Studying the consumption pattern of people abroad
ix. Stimulating creativity to produce new ideas
x. Reducing exports and imports

(5) Preliminary Screening

It refers to elimination of project ideas which are not promising.

The factors to be considered while screening for ideas are:-

♦ Compatibility with the promoter – The idea must be consistent with the interest, personality and resources
of entrepreneur.

♦ Consistency with Government priorities – The idea must be feasible with national goals and government
regulations.

♦ Availability of inputs – Availability of power, raw material, capital requirements, technology.

♦ Adequacy of Market – Growth in market, prospect of adequate sale, reasonable Return on Investment.

♦ Reasonableness of cost – The project must be able to make reasonable profits with respect to the costs
involved.

♦ Acceptability of risk level – The desirability of the project also depends upon risks involved in executing it
(6) Project Rating Index
It is a tool used for evaluating large number of project ideas. It helps in streamlining the process of preliminary
screening. Hence a preliminary evaluation may be converted in project rating index.

Steps to calculate project rating index→

I. Identifying the factors relevant for project rating

II. Assigning weights to these factors according to their relative importance (FW)
III. Rate the project proposal on various factors using suitable rating scale (FR) (5 point scale or 7 point scale)
IV. For each factor multiply the factor rating with factor weight to get factor scores (FR X FW = FS)
V. All the factor scores are added to get the overall project rating index.
Organization determines a cut off value and the project below this cut off value are rejected.

(7) Sources of the Net Present Value

In order to select a profitable and feasible project, a project manager must carry out a fundamental analysis
of the product and factor market to know about entry barriers which lead to positive net present value.

There are six entry barriers which result in a positive NPV project.

They are– i. Economies of scale

ii. Product differentiation
iii. Cost advantage
iv. Marketing reach
v. Technological edge
vi. Government policy

(8)Entrepreneurial skills

An individual must possess the following traits and qualities in order to be a successful entrepreneur –

i. He must be willing to make sacrifices

ii. He must be a good Leader
iii. He must be able to make quick and rational decisions
iv. He must have confidence in the project
v. He must able to exploit market opportunities
vi. He must have strong ego in order to survive ups and downs of a business