1. Project Finance INTRODUCTION Project finance has come of age in India. The promoter/entrepreneur has a wide choice of sources of funds out of which he can choose. The choice, of course, governed by the cost of funds and financial risk. Funds availability should no longer restrict the choice of a project and the technology. The project should be technologically sound, second to none in the world and financially viable. Otherwise the competitive strength would be compromised. Time has come to assess costs and productivity in international terms. The relevance of the project has to be established in international context. A good, sound and viable project would have no problem in finding market acceptance. Project finance is to be financed by borrowing from term lending institutions. Project financing is commonly used as a financing method in capital- intensive industries for projects requiring large investments of funds, such as the construction of power plants, pipelines, transportation systems, mining facilities, industrial facilities and heavy manufacturing plants. The sponsors of such projects frequently are not sufficiently creditworthy to obtain traditional financing or are unwilling to take the risks and assume the debt obligations associated with traditional financings. Project financing permits the risks associated with such projects to be allocated among a number of parties at levels acceptable to each party. HISTORY The origins of project finance can be traced to the construction of the Panama Canal, although the modern origins are the power projects of the 1970s and 1980s where newly created Special Purpose Corporations (SPCs) were created for each project, with multiple owners and complex schemes distributing insurance, loans, management, and project operations. Such projects were previously accomplished through utility or government bond issuances, or other traditional corporate finance structures. Shilpa Bagaria / TYBBI/ Semester V 1

2. Project Finance The new project finance structures emerged primarily in response to the opportunity presented by long term power purchase contracts available from utilities and government entities. These long term revenue streams were required by rules implementing PURPA, the Public Utilities Regulatory Policies Act of 1978. Originally envisioned as an energy initiative designed to encourage domestic renewable resources and conservation, the Act and the industry it created lead to further deregulation of electric generation and, significantly, international privatization following amendments to the Public Utilities Holding Company Act in 1994. WHAT IS PROJECT FINANCING? "Project financing is financing the development or exploitation of a right, natural resource or other asset where the bulk of the financing is not to be provided by any form of share capital and is to be repaid principally out of revenues produced by the project in question". The essence of project lending is therefore its focus on the project being financed. The project lender looks, wholly or mainly, to the project as the source of repayment; its cash flows, and assets where appropriate, are dedicated to service the project loan. The project cannot even begin to provide for repayment until it is operational, and then depends on continued sound operation, so its analysis is critical. Key elements of project financing - The financing of the project is made available and the money is invested before the construction of the infrastructure is completed. - The project lenders have no "recourse" outside the specific project (or only "limited recourse"). This means that the project lenders limit their recourse to the project company's assets and revenues in case the project company is unable to repay its debts. Therefore, there are no guarantees of the project company's obligations to repay loans other than the security provided by itself. Project financing is usually used for: - natural resource projects (mines, hydrocarbons, etc), Shilpa Bagaria / TYBBI/ Semester V 2 3. Project Finance - infrastructure improvements (including power stations) - new industrial plants (factories). DEFINITION 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. It is a method of financing very large capital intensive projects, with long gestation period, where the lenders rely on the assets created for the project as security and the cash flow generated by the project as source of funds for repaying their dues. Shilpa Bagaria / TYBBI/ Semester V 3 4. Project Finance Project Financing Flowchart Preparation of Feasibility Report Acquire Necessary Government Approval and Permission Make Arrangements in Principle for Funding of Working Capital Fill up Loan Application Form Arrange for Site Inspection by Financing Institution Provide Any Clarification Sought by Project Appraisal Team of Financial Institution Examine the Letter of Intent Sign Loan Agreement Initiate Process for Raising Equity Capital Shilpa Bagaria / TYBBI/ Semester V 4 5. Project Finance PRINCIPAL ADVANTAGES AND OBJECTIVES 1. Non-recourse : The typical project financing involves a loan to enable the sponsor to construct a project where the loan is completely "non-recourse" to the sponsor, i.e., the sponsor has no obligation to make payments on the project loan if revenues generated by the project are insufficient to cover the principal and interest payments on the loan. In order to minimize the risks associated with a non-recourse loan, a lender typically will require indirect credit supports in the form of guarantees, warranties and other covenants from the sponsor, its affiliates and other third parties involved with the project. 2. Maximize Leverage: In a project financing, the sponsor typically seeks to finance the costs of development and construction of the project on a highly leveraged basis. Frequently, such costs are financed using 80 to 100 percent debt. High leverage in a non-recourse project financing permits a sponsor to put less in funds at risk, permits a sponsor to finance the project without diluting its equity investment in the project and, in certain circumstances, also may permit reductions in the cost of capital by substituting lower-cost, tax-deductible interest for higher-cost, taxable returns on equity. 3. Off Balance-Sheet Treatment: Depending upon the structure of a project financing, the project sponsor may not be required to report any of the project debt on its balance sheet because such debt is non-recourse or of limited recourse to the sponsor. Off-balance-sheet treatment can have the added practical benefit of helping the sponsor comply with covenants and restrictions relating to borrowing funds contained in other indentures and credit agreements to which the sponsor is a party. 4. Maximize Tax Benefits: Project financings should be structured to maximize tax benefits and to assure that all available tax benefits are used by the sponsor or transferred, to the extent permissible, to another party through a partnership, lease or other vehicle. Shilpa Bagaria / TYBBI/ Semester V 5 6. Project Finance DISADVANTAGES Project financings are extremely complex. It may take a much longer period of time to structure, negotiate and document a project financing than a traditional financing, and the legal fees and related costs associated with a project financing can be very high. Because the risks assumed by lenders may be greater in a non-recourse project financing than in a more traditional financing, the cost of capital may be greater than with a traditional financing. PROJECT FINANCING PARTICIPANTS 1. Sponsor/Developer; The sponsor(s) or developer(s) of a project financing is the party that organizes all of the other parties and typically controls, and makes an equity investment in, the company or other entity that owns the project. If there is more than one sponsor, the sponsors typically will form a corporation or enter into a partnership or other arrangement pursuant to which the sponsors will form a "project company" to own the project and establish their respective rights and responsibilities regarding the project. 2. Additional Equity Investors: In addition to the sponsor(s), there frequently are additional equity investors in the project company. These additional investors may include one or more of the other project participants. 3. Construction Contractor: The construction contractor enters into a contract with the project company for the design, engineering and construction of the project. 4. Operator: The project operator enters into a long-term agreement with the project company for the day-to-day operation and maintenance of the project. 5. Feedstock Supplier: The feedstock supplier(s) enters into a long-term agreement with the project company for the supply of feedstock (i.e., energy, raw materials or other resources) to the project (e.g., for a power plant, the feedstock supplier will supply fuel; for a paper mill, the feedstock supplier will supply wood pulp). Shilpa Bagaria / TYBBI/ Semester V 6 7. Project Finance 6. Product Off taker: The product off taker(s) enters into a long-term agreement with the project company for the purchase of all of the energy, goods or other product produced at the project. 7. Lender; The lender in a project financing is a financial institution or group of financial institutions that provide a loan to the project company to develop and construct the project and that take a security interest in all of the project assets. THE PROJECT COMPANY Legal Form: Sponsors of projects adopt many different legal forms for the ownership of the project. The specific form adopted for any particular project will depend upon many factors, including: the amount of equity required for the project the concern with management of the project the availability of tax benefits associated with the project the need to allocate tax benefits in a specific manner among the project company investors. The three basic forms for ownership of a project are: 1. Corporations: This is the simplest form for ownership of a project. A special purpose corporation may be formed under the laws of the jurisdiction in which the project is located, or it may be formed in some other jurisdiction and be qualified to do business in the jurisdiction of the project. 2. General Partnerships: The sponsors may form a general partnership. In most jurisdictions, a partnership is recognized as a separate legal entity and can own, operate and enter into financing arrangements for a project in its own name. A partnership is not a separate taxable entity, and although a partnership is required to file tax returns for reporting purposes, items of income, gain, losses, deductions and credits are allocated among the partners, which include their allocated share in computing their own individual taxes. Consequently, a partnership frequently will be used when the tax benefits associated with the project are significant. Because the general partners of a partnership are severally liable for all of the debts and liabilities of the partnership, a sponsor Shilpa Bagaria / TYBBI/ Semester V 7 8. Project Finance frequently will form a wholly owned, single-purpose subsidiary to act as its general partner in a partnership. 3. Limited Partnerships: A limited partnership has similar characteristics to a general partnership except that the limited partners have limited control over the business of the partnership and are liable only for the debts and liabilities of the partnership to the extent of their capital contributions in the partnership. A limited partnership may be useful for a project financing when the sponsors do not have substantial capital and the project requires large amounts of outside equity. 4. Limited Liability Companies: They are a cross between a corporation and a limited partnership. PROJECT COMPANY AGREEMENTS Depending on the form of project company chosen for a particular project financing, the sponsors and other equity investors will enter into a stockholder agreement, general or limited partnership agreement or other agreement that sets forth the terms under which they will develop, own and operate the project. At a minimum, such an agreement should cover the following matters: 1. Ownership interest 2. Capitalization and capital calls. 3. Allocation of profits and losses. 4. Distributions. 5. Accounting. 6. Governing body and voting. 7. Day-to-day management. 8. Budgets. 9. Transfer of ownership interests. 10. Admission of new participants. 11. Defaults 12. Termination and dissolution Shilpa Bagaria / TYBBI/ Semester V 8 9. Project Finance PRINCIPAL AGREEMENTS IN A PROJECT FINANCING A] Construction Contract: Some of the more important terms of the construction contract are: 1. Project Description: The construction contract should set forth a detailed description of all of the work necessary to complete the project. 2. Price: Most project financing construction contracts are fixed-price contracts although some projects may be built on a cost-plus basis. If the contract is not fixed- price, additional debt or equity contributions may be necessary to complete the project, and the project agreements should clearly indicate the party or parties responsible for such contributions. 3. Payment: Payments typically are made on a "milestone" or "completed work" basis, with a retain age. This payment procedure provides an incentive for the contractor to keep on schedule and useful monitoring points for the owner and the lender. 4. Completion Date: The construction completion date, together with any time extensions resulting from an event of force majored, must be consistent with the parties' obligations under the other project documents. If construction is not finished by the completion date, the contractor typically is required to pay liquidated damages to cover debt service for each day until the project is completed. If construction is completed early, the contractor frequently is entitled to an early completion bonus. 5. Performance Guarantees: The contractor typically will guarantee that the project will be able to meet certain performance standards when completed. Such standards must be set at levels to assure that the project will generate sufficient revenues for debt service, operating costs and a return on equity. Such guarantees are measured by performance tests conducted by the contractor at the end of construction. If the project does not meet the guaranteed levels of performance, the contractor typically is required to make liquidated damages payments to the sponsor. If project performance exceeds the guaranteed minimum levels, the contractor may be entitled to bonus payments. B] Feedstock Supply Agreements: The project company will enter into one or more feedstock supply agreements for the supply of raw materials, energy or other resources over the life of the project. Frequently, feedstock supply agreements are structured on a "put-or-pay" basis, which means that the supplier must either supply the Shilpa Bagaria / TYBBI/ Semester V 9 10. Project Finance feedstock or pay the project company the difference in costs incurred in obtaining the feedstock from another source. The price provisions of feedstock supply agreements must assure that the cost of the feedstock is fixed within an acceptable range and consistent with the financial projections of the project. C] Product Off take Agreements: In a project financing, the product off take agreements represent the source of revenue for the project. Such agreements must be structured in a manner to provide the project company with sufficient revenue to pay its project debt obligations and all other costs of operating, maintaining and owning the project. Frequently, off take agreements are structured on a "take-or-pay" basis, which means that the off taker is obligated to pay for product on a regular basis whether or not the off taker actually takes the product unless the product is unavailable due to a default by the project company. Like feedstock supply arrangements, off take agreements frequently are on a fixed or scheduled price basis during the term of the project debt financing. D] Operations and Maintenance Agreement: The project company typically will enter into a long-term agreement for the day-to-day operation and maintenance of the project facilities with a company having the technical and financial expertise to operate the project in accordance with the cost and production specifications for the project. The operator may be an independent company, or it may be one of the sponsors. The operator typically will be paid a fixed compensation and may be entitled to bonus payments for extraordinary project performance and be required to pay liquidated damages for project performance below specified levels. E] Loan and Security Agreement: The borrower in a project financing typically is the project company formed by the sponsor(s) to own the project. The loan agreement will set forth the basic terms of the loan and will contain general provisions relating to maturity, interest rate and fees. The typical project financing loan agreement also will contain provisions such as these: 1. Disbursement Controls: These frequently take the form of conditions precedent to each drawdown, requiring the borrower to present invoices, builders' certificates or other evidence as to the need for and use of the funds. 2. Progress Reports: The lender may require periodic reports certified by an independent consultant on the status of construction progress. Shilpa Bagaria / TYBBI/ Semester V 10 11. Project Finance 3. Covenants Not to Amend: The borrower will covenant not to amend or waive any of its rights under the construction, feedstock, off take, operations and maintenance, or other principal agreements without the consent of the lender. 4. Completion Covenants: These require the borrower to complete the project in accordance with project plans and specifications and prohibit the borrower from materially altering the project plans without the consent of the lender. 5. Dividend Restrictions: These covenants place restrictions on the payment of dividends or other distributions by the borrower until debt service obligations are satisfied. 6. Debt and Guarantee Restrictions: The borrower may be prohibited from incurring additional debt or from guaranteeing other obligations. 7. Financial Covenants: Such covenants require the maintenance of working capital and liquidity ratios, debt service coverage ratios, debt service reserves and other financial ratios to protect the credit of the borrower. 8. Subordination: Lenders typically require other participants in the project to enter into a subordination agreement under which certain payments to such participants from the borrower under project agreements are restricted (either absolutely or partially) and made subordinate to the payment of debt service. 9. Security: The project loan typically will be secured by multiple forms of collateral, including: A] Mortgage on the project facilities and real property. B] Assignment of operating revenues. C] Pledge of bank deposits. D] Assignment of any letters of credit or performance or completion bonds relating to the project under which borrower is the beneficiary. E] Liens on the borrower's personal property. F] Assignment of insurance proceeds. G] Assignment of all project agreements. H] Pledge of stock in Project Company or assignment of partnership interests. I] Assignment of any patents, trademarks or other intellectual property owned by the borrower. Shilpa Bagaria / TYBBI/ Semester V 11 12. Project Finance F] Site Lease Agreement: The project company typically enters into a long-term lease for the life of the project relating to the real property on which the project is to be located. Rental payments may be set in advance at a fixed rate or may be tied to project performance. MAIN PROJECT CONTRACTS 1. Concession Agreement The agreement entered into between the sponsors / Project Company and the host government by virtue of which the project company is authorized to develop the project. The main clauses of this agreement involve : - scope of responsibility of the project company and host government, - statutory requirements and host government authorizations, - the description and specifications of the site granted to the project company for the purposes of the development of the project, - the technical specifications of the project, - payments to be made by the project company to the host government (concession fee), - payments to be made to the project company if the host government is the off-taker, - guarantee by the host government of foreign exchange availability and transfer of funds, - tax regime of the project company and the project, - performance guarantee, - reporting and regulation, - Force Majeure, - guarantee against change in circumstances, - duration, - governing law, - dispute resolution. 2. Construction Agreement A construction agreement is the agreement whereby one person (the contractor) agrees to construct a building or a facility for another person (the employer) for an agreed remuneration by an agreed time. In a complex construction project comprised of various interlocking parts (involving both civil and mechanical and electrical works), the basic decision to be taken is whether to have a contractor responsible for all of the works (a "turnkey" contract, contrat de construction cl en main) or to have the individual contractors enter into separate contracts with the employer but to have them subject to control by one overall project manager. Often a turnkey contract is preferred in order to insure that the turnkey contractor assumes overall risk for completion as well as the risk of performance of the sub- contractors. Shilpa Bagaria / TYBBI/ Semester V 12 13. Project Finance The main clauses of this agreement involve : - technical specifications, - authorizations to be obtained for the works, - completion agenda, - testing procedures and performance parameters, - determination of phase / final completion, - fixed price and provision relating to "overruns" and payments, - liquidated damages payable for delay in achieving completion, - transfer of property and risk, - construction bond/completion guarantees (garantie d'achvement), - insurance arrangements, - cooperation and coordination during the works, - final provisions (governing law, dispute resolution etc.). 3. Shareholders Agreement / Joint-Venture Agreement The shareholders of the project company are in most instances the sponsors of the project. Due to the particularities of some jurisdictions and more generally those involved in the management and financing of a project company, the shareholders often enter into a shareholders' agreement. The main clauses of this agreement involve : - voting rights, - nomination of management / major decisions, - dividend distribution, - pre-emption rights, - each shareholder's contribution in equity to the project company and its agenda, - non-dilution, - shareholders loans, - conflict of interests (if one of the shareholders is a party to an agreement to be entered into with the project company), - non-competition clauses, - final provisions. 4. Operating and Maintenance Agreement In most instances the project company will enter into an agreement with an operator which will be responsible for the operation and maintenance of the project facility. The main clauses of this agreement involve : - scope of responsibility of the operator, - operator's fees, - guarantee that the project will achieve certain operating levels (production and efficiency), - operation bonus/liquidated damages, - cooperation and coordination, - operation and maintenance fees, - final provisions. Shilpa Bagaria / TYBBI/ Semester V 13 14. Project Finance 5. Supply Agreements In most instances the project company will need to enter into a number of supply agreements in order to purchase the main supplies for the operation of the project facility. These may include feed stock (raw materials for the manufacturing process), fuel (for electricity generation or for the supply of power to the plant) or renewable equipment. The main clauses of this agreement involve: - level of supply, - price (fixed or indexed), - supply guarantee, - quality of supply, - liquidated damages, - final provisions. 6. Off-Take Agreements A project need not necessarily have an off-take agreement in the sense of a long term product purchase agreement since: - its products may only be capable of being sold on world spot markets (e.g. crude oil), - its revenues may simply be payments from the general public (of tolls or fares). An off-take agreement is a long-term sale agreement of the project products with one or more off-takers with the following characteristics : - long-term sales, - fixed or agreed price, - purchase guarantee ("take-or-pay"). Other The project company will in all instances enter into assurance arrangements. The project company may also enter into a technical assistance agreement. FINANCE DOCUMENTS 1. Loan Agreement This agreement is entered into between the project company and a bank or a syndicate of banks represented by an agent acting in their name and on their behalf if the loan is syndicated. This agreement will provide for the partial financing of the project (since the project will also be financed by equity, subordinated loans, host government subsidiaries, etc.) The loan agreement will contain the following provisions : > Basic Provisions : - general conditions precedent, - conditions precedent to each drawdown, - drawdown mechanics, - interest clause (Euribor, Libor, etc.. plus margin), - repayment clause, - margin protection clauses (gross-up clause, increased costs and market disruption), - illegality clause, - Shilpa Bagaria / TYBBI/ Semester V 14 15. Project Finance representations and warranties, - undertakings, - events of default. > Specific Provisions : - non-recourse or limited recourse clauses, - cover Ratios and Net Present Value, - control accounts (disbursement account, proceeds account, compensation account (for insurance payments), debt service reserve account and a maintenance reserve account), - hedging (protection of a borrower from adverse movements in currency exchange rates, interest rates and commodity prices) Security Package Lenders take security over an asset or a right in order to sell it if their loan is in default and to apply the proceeds against amounts outstanding under the loan. In project finance the lenders' main legal concern is also to ensure : - that they can take effective security over the main project contracts, - that the key contracts remain in place in one from or another if and when they enforce their security. In order to achieve the first concern, each contract must be charged or assigned to the lenders by way of security and any consents required from the other contracting parties for this to occur must be obtained. In order to achieve the second concern, it will be necessary to examine the termination clauses in each contract. Often, there will be provisions entitling the other contracting parties to terminate the contract if the project company is insolvent or if any security it gives is enforced. For this reason, lenders will usually seek to have the provisions amended or to have the other parties enter into direct agreements with them. 2. Direct Agreement Direct agreements are agreements entered into between the project company, the banks financing a project and the parties to the projects' key commercial contracts. The key contracts for these purposes would typically include the concession agreement (if any) the construction agreement, any long-term supply agreement and any long-term sales agreement. Direct agreements are also sometimes sought from the authorities issuing consents necessary for the project. The objective of a direct agreement is basically to enable the banks to "step into the shoes" of the project company if it defaults in its loans obligations. Banks would usually expect a direct agreement relating to a commercial contract to contain the following : Shilpa Bagaria / TYBBI/ Semester V 15 16. Project Finance - consent from the third party to the project company charging or assigning by way of security the project company's rights under the relevant contract (to such extent such consent was required), - an undertaking from the third party that it would not exercise any right it had to terminate the contract without first giving the banks a specific number of days' prior written notice, - an agreement from the third party that, if it gave the banks notice of the type referred to above and the lenders in turn gave it a counter notice, then the third party would either allow the banks (or an agent appointed by them) to assume the project company's rights and obligations under the contract for a specified period of time or allow the transfer of the contract to a separate company (a "work-out" vehicle) established by the banks for this purpose. 3. Intercreditor Agreement The intercreditor issues that arise in project financing are related to situations where there is more than one provider of debt finance. If one layer of finance is to be subordinated to another, an intercreditor agreement will usually set out the terms of the subordination. If no layer of finance is to be subordinated to another, an intercreditor agreement will usually address issues such as whether all of the categories of lenders have to agree before any of them can accelerate their loans or take enforcement action and whether or not any category of lenders is to have the right to veto any proposed exercise of a discretion under any other lenders' credit documentation. Intercreditor agreements will typically contain the following provisions : - voting arrangements and procedural provisions relevant to decision making, - appointment of agents and similar entities to perform specific functions on behalf of groups of lenders, - disclaimer provisions for the benefit of agents, - application of cash as amongst different groups of lenders (not all of them may have the benefit of the same security), - order of application of cash as to specific project and lender requirements ("waterfall" "cascade") Shilpa Bagaria / TYBBI/ Semester V 16 17. Project Finance INSURANCE The general categories of insurance available in connection with project financings are: A] Standard Insurance: The following types of insurance typically are obtained for all project financings and cover the most common types of losses that a project may suffer: 1. Property Damage, including transportation, fire and extended casualty. 2. Boiler and Machinery. 3. Comprehensive General Liability. 4. Worker's Compensation. 5. Automobile Liability and Physical Damage. 6. Umbrella or Excess Liability. B] Optional Insurance: The following types of insurance often are obtained in connection with a project financing. Coverages such as these are more expensive than standard insurance and require more tailoring to meet the specific needs of the project: 1. Business Interruption. 2. Performance Bonds. 3. Cost Overrun/Delayed Opening. 4. Design Errors and Omissions. 5. System Performance (Efficiency). 6. Pollution Liability. Shilpa Bagaria / TYBBI/ Semester V 17 18. Project Finance Feasibility Study After ensuring that a project idea is suitable for implementation, a detailed feasibility study giving additional information on financing, breakdown of cost of capital and cash flow is prepared. Feasibility study is the final document in the formulation of a project proposal. Feasibility studies can be prepared either by the entrepreneur or consultants or experts. The cost of the feasibility study can be debited to the project cost and can be counted as apart of promoters contribution. The feasibility study should contain all technical and economic data that are essential for the evaluation of the project. Before dealing with any specific aspect, feasibility study should examine public policy with respect to the industry. After that, it should specify output and alternative techniques of production in terms of process choice and ecology friendliness, choice of raw material and choice of plant size. The feasibility study, after listing and describing alternative locations, should specify a site after necessary investigation. The study should include a lay-out plan along with a list of buildings, structures and yard facilities by type, size and cost. Major and auxiliary equipment by type, size and cost along with specification of sources of supply for equipment and process know-how has to be listed. The study has to identify supply sources and present estimates, costs for transportation, services, water supply and power. The quality and dependence of raw materials and their source of supply have to be investigated and presented in the feasibility study. Before presentation of the financial data, market analysis has to be covered to help in establishing and determining economic levels of output and plant size. Financial data should cover preliminary estimates of sales revenue, capital costs operating costs for different alternatives along with their profitability. Feasibility study should present estimates of working capital requirement to operate the unit at a viable level. An essential part of the feasibility study is the schedule of implementation and estimates of expenditure during construction. The feasibility study is followed by project report firming up all the technical aspects such as location, factory lay-out specifications and process techniques design. In a way, project report is a detailed plan of follow-up of project through various stages of implementation. A feasibility report should contain inter alias an examination of public policy with respect to the industry, listing of equipment by type, size and cost and Shilpa Bagaria / TYBBI/ Semester V 18 19. Project Finance specification of sources of supply for equipment, broad specification of outputs and alternative techniques of production in terms of choice of process, plant size and raw material, listing and description of alternative location, capital costs, estimates of sales revenue and operating costs for different alternatives, estimation of demand for product, sources of raw material supply, listing of buildings and structures by type, size and cost, specification of supply sources and costs for transportation services, water supply and power, preparation of layout, labor requirement and cost, working capital requirement, plan for execution of project and expenditure during construction , analysis of profitability, pollution control method and experience of promoters in execution of projects in the past. Preparation of the Feasibility Report The feasibility report of an investment proposal provides the information required by the decision makers for appraising the proposal. The initial appraisal is done at the strategic planning level of an organization. In the case of new projects the promoters have to carry out this function. The feasibility report is then submitted to financial institutions for assistance and relevant government departments for necessary permissions. The feasibility report lies between the project formulation stage and the appraisal and financing stage. First Step in a Project Financing: The Feasibility Study. A] Generally: As one of the first steps in a project financing the sponsor or a technical consultant hired by the sponsor will prepare a feasibility study showing the financial viability of the project. Frequently, a prospective lender will hire its own independent consultants to prepare an independent feasibility study before the lender will commit to lend funds for the project. B] Contents: The feasibility study should analyze every technical, financial and other aspect of the project, including the time-frame for completion of the various phases of the project development, and should clearly set forth all of the financial and other assumptions upon which the conclusions of the study are based, Among the more important items contained in a feasibility study are: Shilpa Bagaria / TYBBI/ Semester V 19 20. Project Finance Description of project. Description of sponsor(s). Sponsors' Agreements. Project site. Governmental arrangements. Source of funds. Feedstock Agreements. Off take Agreements. Construction Contract. Management of project. Capital costs. Working capital. Equity sourcing. Debt sourcing. Financial projections. Market study. Assumptions. Shilpa Bagaria / TYBBI/ Semester V 20 21. Project Finance THE STAGES OF PROJECT SELECTION The identification of project ideas is followed by a preliminary selection stage on the basis of their technical, economic and financial soundness. The objective at this stage is to decide whether a project idea should be studied in detail and to determine the scope of further studies. The findings at this stage are embodied in a prefeasibility study or opportunity study. For the purpose of screening and priority fixation, project ideas are developed into prefeasibility studies. Prefeasibility studies give output of plant of economic size, raw material requirement, sales realization, and total cost of production, capital input/output ratio, labor requirement, power and other infrastructure facilities. The project selection exercise should also ensure that it conforms to overall economic policy of the government. PROJECT IDENTIFICATION A project is a proposal for capital investment to develop facilities to provide goods and services. The investment proposal may be for setting up a new unit, expansion or improvement of existing facilities. The project, however, has to be amenable for analysis and evaluation as an independent unit. A project is a specific, finite task to be accomplished in order to generate cash flows. The projects undertaken after liberalization are large and getting larger. They have increased in size and complexity. Projects for tomorrow are not geared to the mass production of simpler goods but customized ones produced by flexible manufacturing systems. Project idea can be conceived either from input or output side. The former are material based while the latter, demand oriented. Input based projects are identified on the basis of information about agricultural raw materials, forest products, and animal husbandry, fishing products, mineral resources, human skills and new technical process evolved in the country or elsewhere. Output based projects are identified on the basis of needs of population as revealed by family budget studies or industrial units as found by market studies and statistics relating to imports and exports. Desk research surveying existing information is economical and wherever necessary market surveys assessing demand for the output of project could help not only in identification but in assessing viability of the project. Shilpa Bagaria / TYBBI/ Semester V 21 22. Project Finance Project identification is however a continual process. With the opening up of the economy, demand for sophisticated inputs is continuously rising. The quest for new combinations of factors for optimizing output and improving productivity to strengthen the competitive position of Indian industry in the international market place is an ongoing process. Further, the growing demand for complex, sophisticated, customized goods and services in international markets has added a new dimension to project concept. Objectives and Tasks in Implementation of Projects The implementation phase consists of two sub-phases: (1) Pre-operation phase (2) Operation phase. The pre-operation phase may be considered to be complete when various components of the project are installed and put into operation. The pre- operation phase of the implementation begins when the feasibility report has been completed and financing has been arranged. Objectives in Pre-Operation and Operation Phases The objectives of the project management system in the pre-operation phase are as follows: (1) Completion of the project on time (2) Completion of the project within contemplated costs (3) Completion of the project at a profit to the company The primary objective of the project managerial system, when the unit becomes operational, is to operate it profitably by promoting optimal utilization of the installed capacity. At this stage, it is also necessary to look for opportunities of growth and diversification. Thus it becomes necessary to take recourse to every available modern management technique to achieve the implementation objectives. The dimension of the problems faced at this stage can be brought out by first discussing the tasks of the project manager in the implementation of a project and the usual problems in implementation. Shilpa Bagaria / TYBBI/ Semester V 22 23. Project Finance Tasks of the Project Manager The project managers tasks can be divided into four categories: (1) Technical (2) Personnel (3) Administrative (4) External Relations The tasks relating to the technical aspects are planning, scheduling of work, setting of priorities, task identification, looking into the logistics, and specification of equipment use. The personnel aspect involves building up of organization and recruitment of staff as per the requirements, leading and motivating the staff to perform, building communication channels, resolution of conflicts, conducting negotiation with various parties, and performance evaluation. Administrative tasks include estimating and controlling of costs, budgeting, cash flow monitoring, devising and using the management information system, evolving systems and procedures for various operations including the procurement of raw materials, and finally the terminal project evaluation. The project manager has also to manage the external relations of the unit. These tasks include relations of the unit. These tasks include relations with financial institutions, contracting and using the consultants, dealing with suppliers and sub-contractors, and co-ordination with other agencies including government agencies. All the above mentioned tasks of the project manager need to be performed at both pre-operation and operation phases of a unit. Then nature and complexity of these tasks are, however, different in the operation phase as compare to the pre-operation phase. Shilpa Bagaria / TYBBI/ Semester V 23 24. Project Finance Problems in Pre-Operation Phase The most important problem faced in the implementation phase of the project is delay in the execution of projects. It has been observed that as many as 95 percent of the projects taken up by the public sector could not be completed in time and sometimes delays were even more than 50 percent of the time in which a project was expected to start functioning. The problem of delay in the project management terminology is also referred as the slippage of projects. The slippage of projects results in escalation of costs and also the losses of revenue, and thereby making the initial assumptions made in the feasibility report completely out of line. The delays are generally caused by the two main factors: Delays caused by internal factors and delays caused by external factors. 1] Delays Caused by Internal Factors: The delay is often caused by the inadequate work at the planning stage resulting in the preparation of feasibility reports based on wrong and inadequate information. If the feasibility report is not comprehensive enough or based on ideal conditions, there are bound to be problems in executing the project. The project implementation also gets delayed if there is a co-ordination among various components and departments involved in the implementation of the project. Very often when there are several departments involved in the implementing the project, it suffers due to their different attitudes to the project with different conditions under which they perform with out inter linking the combined sense of accountability to the final completion of the project. Apart from the problems of planning and co-ordination of work the delays are also caused by lack of delegation of adequate authority to the lower levels of the organization which are actually involved in implementing the work. Sometimes over emphasis on accountability and legal propriety of expenses cause delays. The process of decision making in the pre-operation phase gets delayed because the accountability is not simple, clear, and effective at all the levels of the organization so that it can cope with other factors causing delays in implementation. At the pre-implementation phase, the delays are caused due to selection of contractors who have inadequate experience or who are incapable of Shilpa Bagaria / TYBBI/ Semester V 24 25. Project Finance handling such a project. In most of the contracts, terms and conditions are not laid down in clear language which provides enough room for disputes at later stages causing stoppage of work at a crucial point upsetting the entire process. Contract documents do not include the realistic terms and conditions as per requirements of the project, schedule of construction of different phases, and other sub-contracted jobs. Of course, delays also occur in preparation of the contract document, selection of contractors through tenders, and signing of contracts. 2] Delays Caused Through External Factors: There are several factors which are not under the control of the project manager and which contribute to the delays. For example, the supply of machinery on the site, raw materials equipment or any other inputs needed as per the programmed of construction or installation of mechanical or electrical systems often lead to the delay in the projects. Some of the delays in the supply schedules are very difficult to envisage at the time of the preparation of a feasibility report. There is also a problem of time gap between the submission of project proposal and final approval by the financial institutions, government, and others. The delays in the supply of machinery and equipment at the site are also caused by the delays in the transportation process involved in the movements of supply of goods. Even the release or delivery of consignment from railways is not very smooth. Non-availability of wagons, rakes, and the man-made scarcity of wagons are some of the important crucial factors causing the slippage of new projects. These are further aggravated by the complicated and lengthy procedure of imports, issue of licenses, clearance, supply of steel and cement by various agencies, etc. Shilpa Bagaria / TYBBI/ Semester V 25 26. Project Finance Tasks of Project Manager in Pre- Operation and Operation Phases (Fig.1) The Project Manager 1. Technical Aspects 2. Personnel 3. Administration 4. External Relations Technical Aspects 1. Planning, Scheduling 2. Setting of Priorities 3. Task Identification 4. Logistics 5. Equipment Use and Schedules Personnel 1. Organization and Staffing 2. Leading and Motivating 3. Communication 4. Resolution of Conflicts 5. Negotiation 6. Performance Evaluation Administration 1. Estimating and Controlling Cost 2. Budgeting 3. Cash Flow Monitoring 4. Management Information System 5. Systems and Procedures 6. Terminal Project Evaluation External Relations 1. Relation with Financial Institutions 2. Contracting and Use of Consultants 3. Dealing with Suppliers and Sub- Contractors 4. Coordination with Other Agencies Shilpa Bagaria / TYBBI/ Semester V 26 27. Project Finance Operating Procedures for Getting Working Capital The working capital is the amount of funds which a unit needs to finance its day-to-day operations and in this sense it can be regarded as that part of the total capital which is employed in the short-term operations. The constituents of the working capital are stocks of raw materials and suppliers, work-in-progress, finished goods, book debts and the minimal cash, and bank balances. The working capital needs of the unit are essentially to be met by borrowings from the commercial banks. Till recently there were no standards or guidelines for setting out the precise amount of gross or net working capital needed by various enterprises. Recently however, a particular study group which looked at the question suggested the guidelines with a view to: (1) make customer plan his credit needs in advance and observe discipline in its use; (2) indicate to the banker the likely demand for credit and thus enable him to plan his own deposit-credit function; (3) assure finance to industry for its genuine production needs; (4) having provided finance, enable the banker to receive from the customer adequate flow of information on the use of credit, but within- built flexibility to suit changes in circumstances. As per the guidelines of the committee, the commercial banks have to understand and interpret the extent of working capital gap in borrowers business at any given time and decide the appropriate method of arriving at the maximum permissible level of bank credit to the borrower. The study group presented three alternatives, which can also be considered at three sequential stages, for deciding the maximum permissible bank finance: Method I: Determine the working capital gap, i.e. a reasonable level of total current assets minus non-bank current liabilities and reckon 75 percent of the working capital gap as the permissible level of bank finance. The balance has to be found by the borrower from his own funds and/or from long-term borrowings. Method II: The borrower will have to get his own resources and/or long-term funds to finance 25 percent of the total current assets. Whatever is then required to meet the working capital gap will be provided by the banker. Method III: Determine the core current assets. These have to be financed out of own fund and/or long-term borrowings. The reasonable level of total current assets less core current assets will represent real current assets. Twenty-five percent of real current assets Shilpa Bagaria / TYBBI/ Semester V 27 28. Project Finance will also have to be supported by the borrowers own funds and/or long-term borrowings. If the non-bank current liabilities are inadequate to cover the balance 75 percent of the real current assets, the required amount will be obtained by way of bank borrowings. Problems in the Operation of a Unit After completion of the pre-operation phase, the unit became operational. Some of the problems can be traced back to faulty project formulation; others arise because of internal working of the project or change in the external environment. 1] Faulty Project Formulation and Implementation Faulty project formulation and handling in the pre-operation phase leads to problems in the operation phase of the project. Faulty project formulation can often be traced back to faulty product selection, doubtful financial viability and wrong location which would lead to problems in using the installed capacity. The problems caused by faulty project formulation and implementation often require additional finance and nursing of the units. 2] Non-availability of Raw Materials Incase of industrial projects, raw materials constitutes a very substantial portion of the cost of production. Therefore, any problem in procuring raw materials at a reasonable price leads to a situation of under utilization of capacity, higher breakeven capacity, and lower profitability unless the output prices can also be changed accordingly. Again the output prices of many industries are under government regulation and control which makes it difficult to look after the output prices in proportion to cost escalation. Raw material problem may also arise because of a change in government policy with respect to imports of those materials. Apart from raw materials, power cuts and lack of other utilities also cause problems in utilization of installed capacity. If an industry uses continuous process, much time is lost in putting the process back into operation after the power cut. 3] Poor Financial Management Problems arising out of poor financial management can be usually traced to low equity base, false investment decisions, working capital difficulties, loose Shilpa Bagaria / TYBBI/ Semester V 28 29. Project Finance accounting, costing and record keeping. Although the debt-equity ratio and the promoters contribution requirements have been considerably liberalized, in practice entrepreneurs need higher equity base to at last tide over unforeseen cost escalations. In the absence of such a base, even managerial cost escalations create problems for functioning of the unit. It has also been observed, particularly in the case of industrial units, that the working capital requirements are not anticipated and forecasted well. Therefore, commercial banks grant the working capital limits which are not sufficient to take care of various production and marketing requirements. When the unit begins to face the constraint of working capital, production suffers. Bankers became reluctant to grant additional limits. The unit then gets into the vicious circle. Lack of project accounting, costing, and record keeping makes the cost control and pricing decisions difficult, leading to financial problems. This is observed more so in the case of several industrial units where there are no qualified accountants. Once the problems crop up, banks begin to ask for various kinds of data which is difficult for these units because the data simply do not exist in that form. Problems of Industrial Relations and Operating Style Shilpa Bagaria / TYBBI/ Semester V 29 30. Project Finance Industrial parce and workers co-operation are key factors in realizing production build-up as anticipated. Units get into difficulty in early stages because of labour problems. Some of the labour problems can be traced to the operating styles of the entrepreneur and lack of managerial effectiveness. Sometimes promoters themselves do not operate as a cohesive group. There are cases where doubleful integrity and entrepreneurial commitment to project on the part of promoters cause problems for operating the unit profitably 1. Marketing Problems Many small scale and industrial units face problems in marketing their products. Some of these problems can be traced back to inadequate market analysis at the project formulation stage. Other marketing problems arise because of inappropriate marketing strategy and or low-key market development effort. Some of the industrial products require longer gestation periods than initially expected in developing the tastes and clientele. 2. Environmental Problems These are problems that arise from changes in external environment faced by the unit. These changes arise because of changes in government policies and/or critical shortages of raw material and utilities. For example, time to time serious shortages of coal and power cuts cause problems for production. Ban on movement of final product also creates problems in realizing the remunerative prices and, therefore, problems of capacity get aggravated. 3. Technical Production Problems Very often, particularly in the case of indigenously developed technology, problems arise in the process of expanding pilot plants to commercial scale units. The know-how is not fully technically foolproof. In case of the imported know- how also, shortage of spares and critical equipment break-downs causes production break-down. Without appropriate production build-up, a whole host of problems discussed above arise. Sometimes the technical production problems can be traced to the improper scheduling and monitoring of production. This aspect can also be linked with lack of managerial effectiveness. Types of Ratios Shilpa Bagaria / TYBBI/ Semester V 30 31. Project Finance 1. Pay back Period (P): The pay back period is defined as the time period within which the initial investment on the project is recovered by the unit in the form of revenues. To put it differently this is the length of time between the initial investment on the project and the time when this initial investment is completely recovered from the net yearly revenues. In symbolic terms if the net yearly cash flows are same every year, we can express the pay back period as follows: P= I C Where P is pay back period I is the initial investment and C is the yearly net cash inflow. 2. Net Present Value (NPV): The net present value of investment is calculated by taking a discounted sum of the stream of net income during the expected life of the project It is necessary to discount the future stream of net income because costs and returns in different time periods are not strictly comparable. In symbolic terms we can express the NPV of a project generating net cash flows of R1, R2, R3, ., Rn for n years as follows: NPV = R1 + R2 + + Rn -I (1+ r) (1+ r) (1+ r) where 100 r percent is the discount rate. The investment is considered sound if the NPV is positive. A negative NPV indicates that the project is not worth considering at a given discount rate. 3. Internal Rate of Return (IRR): The internal rate of return is that rate of return which makes the net present value equal to zero. Thus, it is the discount rate which makes the initial investment in the project equal to the discounted net returns from the investment during the entire life of the project, In symbolic terms we can express it as: n Rt - I = 0 (1 + r) t t = 0 where Rt are the net returns in each of the n years and (1 + r)t is the discount factor. In this case R is to be estimated such that the discounted net returns from the project equal zero. The estimated value of R is then compared with the cost of capital. If the internal rate of Shilpa Bagaria / TYBBI/ Semester V 31 32. Project Finance return (IRR) is higher or equal to the minimum desired yield or rate of return, then we accept the project proposal. Otherwise, the project is rejected and as a corollary to this between the two projects if one yields higher IRR than the other, the first one is preferred to the second. To enable the entrepreneurs to form a judgment about the efficiency of the enterprise, creditworthiness, and his return on key aggregates, some financial ratios can be computed from the projected financial statements of the unit. 4. Efficiency Ratios: As the name indicates these ratios provide information on the efficiency of the proposed industrial unit. Some of the important ratios in this regard include inventory include turn-over and operating ratios. 5. Inventory Turnover Ratio: The inventory turnover is computed as follows: sales are divided by the inventory. This ratio measures the number of times the unit turns over its stock each year and indicates the stock of inventories required to stock a given level of sales. It is generally observed that in agro-processing industries this ratio is lower compared to other industries because of their seasonal operations. It is also observed that industrial units have to generally keep several months of inventories to support their processing operations and production schedules. A lower ratio also implies that sizable amount of funds are locked up in inventory for long times. It is to be judged whether the computed ratio is reasonable, given the conditions and practices prevailing generally in that industry. 6. The Operating Ratio: This ratio is computed by dividing the operating expenses with the revenue. This ration indicates the ability of the unit to control operating costs including overhead expenses. This ratio is generally used in comparing the performance over the time of the same unit or comparing the performance of he proposed unit with that of other units. If it is observed from the projected statements that the ration increased over time, it implies either the cost of raw materials is increasing or the labour cost is increasing or there are wastages in the production process and/or there is substantial competition necessitating a reduction in prices. When the operating ratio becomes very high the unit may have difficulty in making an adequate return. On the other hand, if this ratio is very low, one has to examine whether some of the cost items have been omitted. Shilpa Bagaria / TYBBI/ Semester V 32 33. Project Finance 7. Income Ratio: An entrepreneur has to examine whether the projected enterprise would be able to provide or generate resources for reinvestment and growth and its ability to provide a reasonable return on investment. The most important income ratios are: (1) Return on sales, (2) Return on equity, and (3) Return on assets. These income ratios vary from year to year. Therefore these need to be computed for each year from the projected statements for the unit. (A) Return on sales: This ration indicates the operating margin of the unit on its sales. If the return on sales or the operating margin is low it implies that the unit will have to have a large volume of sales in order to earn an adequate return on investment. This ratio is usually used for comparison purposes with the units in the same industry or the same unit over time. Since the acceptable level of the ratio varies from industry to industry it is meaningless to compare this ratio across industries. (B) Return on Equity: This ratio is computed by dividing the net income after tax by equity. This ratio helps the entrepreneurs to compare various investment opportunities and select the project proposal which yields a satisfactory return on investment. (C) Return on assets: This ratio indicates the earning power of the assets of the proposed unit and it is computed by dividing the operating income by the value of assets. If the proposal is to be acceptable for entrepreneurs, the return on assets should exceed the cost of capital; otherwise the project is not viable from the point of view of the entrepreneurs in the sense this ratio is close to the calculations or indicators of the financial viability in the previous section. 8. The Creditworthiness ratio: These ratios indicate the degree of financial risk inherent in the enterprises before going for them. These ratios also indicate the type of financing and term the proposed unit would require so that it may be able to survive even the adverse circumstances. Some of the important ratios in this category are the current ratio, the debt-equity ratio, and the debt-service coverage ratio. 9. The Current Ratio: This ratio is computed by dividing the current assets by the current liabilities. This is an important ratio for the lending agencies to assess the enterprise in terms of the margin that the proposed unit has for its current assets to shrink in value Shilpa Bagaria / TYBBI/ Semester V 33 34. Project Finance before the unit gets into difficulty in meeting its current obligations. The appropriate level of this ratio depends on the type of industry and trade practices in in the industry where the proposed unit would belong. For example, if the unit has a large inventory turnover and if it can collect its accounts receivables promptly, then the current ratio can be lowered. If the current ratio is very low then, the unit has to exist on a day-to-day basis which may led to uneconomic practices because it is possible that its output may have to be sold at lower prices for cash, or it may be able to carry sufficient inventory to meet the production schedules, or it may have to buy inventories in small lots and, therefore, pay higher prices for the inventories, etc. Once again, the appropriate level of this ratio for the proposed unit will have to be judged in the light of other ratios as indicated. 10. Debt-equity Ratio: This ratio is computed by dividing the long-term liabilities by the sum of long-term liabilities plus equity to obtain the proportion that long-term liabilities are to total debt and equity, and then by dividing equity by the sum of long-term liabilities plus equity to obtain the proportion that equity is to the total debt and equity. 11. The Debt Service Coverage Ratio: This ratio can be computed on a before-tax basis or after-tax basis. If the debt service coverage ratio is computed on a before-tax basis, it implies that the funds from operations have been divided by interest plus repayment of long-term loans. If the calculations are done on after-tax basis, it implies that the taxation expenses have also been taken out and, therefore, it is even sounder. This ratio is computed as the net income plus depreciation less interest paid divided by interest paid plus the payment of long-term loans. It is again very difficult to ascribe any rule of thumb for the debt-service coverage ratio. This ratio has been interpreted along with the analysis of sources and uses of funds for the unit and the pool of funds remaining after all requirements for maintenance and improvements of current operations and orderly expansion. If the ratio decreases over time, it may be due to the over-ambitious expansion programmed or change in credit terms which have lengthened the repayment period, etc. APPRAISALS IN PROJECT FINANCE 1. TECHNICAL APPRAISAL Shilpa Bagaria / TYBBI/ Semester V 34 35. Project Finance A] Appraisal of project At the outset it may be clarified that the terms evaluation, appraisal and assessment are used interchangeably. They are used in analyzing the soundness of an investment project, i.e., in an ex ante analysis of the effects of implementing a project. The analysis is based on projections in terms of cash flows. The analysis is carried out by the entrepreneur or promoters of the project, the merchant banker who is going to be involved in the management and underwriting of public issue and financial institutions who may lend money. Evaluation of industrial projects is undertaken to compare and evaluate alternative opportunities in terms of projects exist for commitment of resources. Project selection can only be rational if it is superior to others in terms of commercial profitability i.e. net financial benefits accruing to owners of the project or on national profitability i.e. net overall importance of the project to the nation as a whole. The purpose of the project appraisal is to ensure that the project is technically sound, provides reasonable financial return and conforms to the overall economic policy of the country. B] Objectives Technical appraisal is primarily concerned with the project concept covering technology, design, scope and content of the plant as well as inputs and infrastructure facilities envisaged for the project. Basically, the project should be able to deliver marketable product from the resources deployed, at the cost which would leave a margin adequate to service the investment and plough-back a reasonable amount to enable the enterprise to consolidate its position. Technical appraisal has a bearing on the financial viability of the project as reflected by its ability to earn satisfactory return on the investment made and to service equity and debt. C] Project Concept Project concept comprises various important aspects such as plant capacity, degree of integration, facilities for by-product recovery and flexibility of Shilpa Bagaria / TYBBI/ Semester V 35 36. Project Finance the plant. Accurate assessment of plant capacity on a sustained basis is of crucial importance. D] Capacity of the Plant Capacity of a plant depends on several factors such as product specification, product mix and raw material composition. It is indeed difficult to assess capacity. In a textile mill, capacity varies with the composition of yarn of different counts. The additional investment would improve the profitability enormously. E] Flexibility of Plant and Flexible Manufacturing Systems While assessing a project, flexibility of the plant should be allowed in the design of individual pieces of equipment. Flexible manufacturing systems are the emerging systems to manufacture what the customer wants. These systems help in the production of a large variety of products. F] Evaluation of Technology Outstanding features of technology process, engineering design and plant and machinery are established facts and can be checked from published information on the process or from prospective collaborators/consultants and on the basis of similar plants in operation elsewhere. However, considerable skill is required in evaluating the claims of emergent technology, products and equipment design. The design and layout of the plant in technical appraisal should ensure ease of operation and convenience of maintenance and uncomplicated expansion of the stream capacity, should the need arise. Above all, in technical appraisal one should be alert and apply trained and informed skills. For example, the availability of soft water is essential for a textile processing plant. It is on record that a public sector textile processing plant was set up without checking the quality of water. The result was a large additional investment to cure water. G] Inputs In technical appraisal, inputs are scrutinized for availability and quality dependability. If there are seasonable variations, especially, in the case of Shilpa Bagaria / TYBBI/ Semester V 36 37. Project Finance agricultural inputs, variations in price have to be checked. Similarly power quality has to be checked in terms of variation in supply voltage and in-line current frequency and duration of black-outs. H] Location While it is easy to enumerate desirable factors to be taken into account while determining location, in practice various constraints dictate location away from the ideal one. The ideal factors are of course, proximity to the market and inputs, preferably where well developed infrastructure exists. In some industries effluent disposal facility is necessary. Pollution control restricts the use of steam boilers while power scarcity restricts the installation of induction furnaces which are environment friendly. Antipollution regulations may also force the choice of large size plants to curtail noise pollution or to install anti-vibration equipment with adverse impact on costs. I] Interdependence and Parameters of Project Finally, the technical appraisal of the individual project may be supplemented by a supplementary review of the project in terms of interdependence of the basic parameters of the project which are, plant size, location and technology. A small integrated paper plant using bagasse, paddy husk or straw without need to recover process chemicals may be more viable than large integrated paper mill requiring forest based raw material, water and effluent disposal system. Sometimes undependable supply of basic inputs could spell disaster. The implementation of the project has cost and time over-run implications. The scheduling of construction and the identification of potential causes of delay form an important part of the technical aspects of the project appraisal. The schedule of construction depends mainly on the speed of civil construction works, delivery period of equipment, as well as the efficiency of the management to tie-up various ends in a coordinated and speedy manner. Since an over run in the pre- commissioning time invariably leads to over run in cost and consequential problems, it is important that timing of construction is realistically planned. For all main physical elements of the projects, from project concept, obtaining Government approvals, tying-up financial arrangements, engineering design, land acquisition, building construction, procurement of equipment, its erection and testing to final Shilpa Bagaria / TYBBI/ Semester V 37 38. Project Finance commissioning, there must be realistic time schedules and a coherent arrangement, which leads to the completion of the project on most economical basis. J] Project Charts and Layouts Project charts and layouts have to be prepared to define the scope of the project and provide the basis for detailed project engineering. These are general functional layout, material flow diagram, production line diagram, utility layout and plant layout. General functional layout should facilitate smooth and economical movement of raw materials, work-in-process and finished goods. Material flow diagram presents flow of materials, utilities, intermediate products, final products, scrap and emissions. Production line diagram establishes the progress of production from one machine to another with description, location, space required, need for power and utilities and distance from the next section. Utility layout shows the principal consumption points of power, water and compressed air which help in the installation of utility supply. Finally, plant layout identifies the exact location of each piece of equipment determined by proper utilization of space leaving scope for expansion, smooth flow of goods to minimize production cost and safety of workers. K] Cost of Production Estimates of production costs and projection of profitability is the concluding part of the technical appraisal. Cost of production is worked out taking into account the build up of capacity utilization, consumption norms for various inputs and yields and recovery of by-products. In estimating production, a general build-up starting with 40 percent and reaching a normal level of 80 percent in three to four years time is provided. In practice capacity utilization may fall short of estimated levels on account of defective plant and machinery, inadequate operating skills, inadequacy of raw materials, shortage of power and lack of demand. The cost of production and profitability estimates take into account the level of production in different years and product mix, norms of raw material consumption, power and fuel requirement, their costs, salaries and wages, repairs and maintenance, administrative overheads, selling expenses and interest on borrowings. Adequate provision is made for higher expenses in the initial years for technical troubles, Shilpa Bagaria / TYBBI/ Semester V 38 39. Project Finance higher wastages and lower yields, lower operating efficiency and higher selling costs. Here, too, comparison with similar projects is useful. The profitability estimates should be on a realistic selling price. In a competitive market, penetration price for a new producer will have to be lower than the current price of an established manufacturer 2. MARKET APPRAISAL a. Introduction Analysis of demand for the product proposed to be manufactured requires collection of data and preparation of estimates. Market appraisal requires a description of the product, its major uses, scope of the market, possible competition from substitutes, special features of the product proposed to be manufactured in regard to quality and price which would result in consumer preference for the product in relation to competitive products. Estimates have to be made about existing and future demand and supply of the products proposed to be manufactured. An assessment of likely competition in future and special features of the project which may enable it to meet competition has to be made. Export possibilities have to be identified and comparative data on manufacturing costs have to be compiled. It is necessary to identify principal customers and state particulars of any firm arrangements entered into with them. Selling arrangements contemplated in terms of direct sales or through distributors or dealers have to be classified. After collection of data, the existing position has to be assessed to ascertain whether unsatisfied demand exists. Since cash flow projections are to be made possible future changes in the volume and the pattern of supply and demand have to be estimated. This would help in assessing the long term prospects of the unit. Estimation of demand requires the determination of the total demand fr the product and the share that can be captured by the unit through appropriate marketing strategies. The commonly used methods of demand forecasting are trend, regression and end-use methods. b. Trend Method The trend method assumes that the behavior of the variable would continue in the same direction and magnitude as in the past. In this method, it is useful first to draw a Shilpa Bagaria / TYBBI/ Semester V 39 40. Project Finance graph to ascertain whether a linear or an exponential trend is appropriate for projection. The assumption under linear trend is that the variable would increase by a constant amount, whereas in exponential it will change by a constant percentage amount. Graphing the data will help to decide which period to choose and what type of form be used for forecasting. Only after analysis of past data the trend line should be fitted. c. Regression Approach In regression approach the factors influencing the variables that are to be forecast have to be identified. In this method we have the dependent variable and the explanatory or independent variable. The dependent variable is the one subject to forecasting. The explanatory variables are those which cause changes in the dependent variable. If the rate of inflation is to be forecast, the independent variables may be money supply, per capita availability of food grains and rate of monetization of the economy. Specification or identification of factors is crucial in forecasting by regression approach. In multiple regressions we have more than one explanatory variable. The regression coefficients should have the right sign and be statistically significant. The actual value of dependent variable and the estimated value should be close to each other for the sample period. d. End-Use Method In this method the users of the product, proposed to be manufactured, are identified. An intensive study of the past and present situation and a through assessment of the future prospects of the various end user industries. A study of the consumption norms for each end user industry in respect of the product for which forecasts are needed is also made. However, provision should be made for changes in the norms as a result of technological change or emergence of substitute products. The end use approach enables customer industry wise demand forecasts and it is easy to evaluate any discrepancy in the forecasts with the actual value. The method is appropriate for intermediate industrial products such as steel and caustic soda. Demand projections and estimates are made by agencies of government as well as industry associations. Among the government agencies, the Directorate General of Technical Development and the Planning Commission may be mentioned. Several Associations of manufacturers make estimates. In regard to small scale sector, the Development Commissioner for Small Scale Industries, the National Small Industries Corporation and the Small Industries Services Institute provide valuable market Shilpa Bagaria / TYBBI/ Semester V 40 41. Project Finance information about projects and products. Several private consultants undertake market surveys for the fee The key elements of market appraisal, both informal as well as formal, are (1) Consumer analysis, (2) Competitive environment analysis, (3) Preparation of marketing plans, and (4) assessment of market potential and demand forecasting. These key elements are discussed in detail in subsequent paragraphs. 3. FINANCIAL APPRAISAL a. Introduction Financial appraisal is concerned with assessing the feasibility of a new proposal for investment for setting up a new project or expansion of existing productive facilities. This involves an assessment of funds required to implement the project and the sources of the same. The other aspect of financial appraisal relates to estimation of operating costs and revenues, prospective liquidity and financial returns in the operating phase. In appraising a project, the projects direct benefits and costs are estimated at the prevailing market prices. This analysis is used to appraise the viability of a project as well as to rank projects on the basis of their profitability. It may be noted that financial appraisal is concerned with the measurement of profitability of resources invested in the project without reference to their source. For the purpose of appraisal it is necessary to make estimates relating to working results in case of existing concerns, cost of the project and the means of financing. Financial projections for a ten year period have also to be made. b. Working Results of Existing Units In the case of an existing unit, it is desirable to make an assessment of its latest financial position. For this purpose, its latest audited balance sheet and profit and loss statement as well as the balance sheets for the last five years have to be analyzed. In case an audited balance sheet as on a fairly recent date is not available, a proforma balance sheet and profit and loss statement certified by the management may be examined The latest balance sheet and profit and profit and loss account may be analyzed with a view to ascertaining, whether the concern is under/over capitalized, whether the borrowings raised are not out of proportion to its paid up capital and reserves, how the current liabilities stand in relation to current assets, whether the gross block has Shilpa Bagaria / TYBBI/ Semester V 41 42. Project Finance been properly depreciated and has not been shown at an inflated value, whether there is any inter-locking of funds with associate companies and whither the concern has been ploughing back profits into the business and building up reserves. c. Cost of the Project The capital cost of the project whether it pertains to expansion or a new project should be shown under, (a) land and site developments, (b) buildings, (c) plant and machinery, (d) technical know-how fees, (e) expenses on foreign technicians and training of Indian technicians abroad, (f) miscellaneous fixed assets, (g) preliminary and pre-operative expenses, (h) provision for contingencies and (i) margin money for working capital. It has to be ensured that all these items are covered in the cost and the expenditure under each item is reasonable. As a part of the process of an appraisal of the capital cost of the project, it is desirable to compare the cost of the project with the cost of the similar project or by the information about cost that may be gathered in respect of other units in the same industry with comparable installed capacity and other common technical features. d. Sources of Finance The usual sources of finance for a project are: Equity capital, term loan, deferred payment, unsecured loans from promoters and internal accruals in the case of an existing unit. A balance has to be struck between debt and equity. A debt equity ratio of 1:1 is considered ideal but it is relaxed up to 2:1 in suitable cases. Further relaxation in debt equity is made in the case of capital intensive projects. All long term loans/deferred credit are treated as debt while equity includes free reserves. Equity is arrived after deducting carried forward losses in the case of an existing unit. The norm for promoters contribution in the project is 22.5 percent of project cost with a lower contribution for projects promoted by technical entrepreneurs. Normally Shilpa Bagaria / TYBBI/ Semester V 42 43. Project Finance the promoters contribution should be brought in by way of equity capital. If unsecured loans from promoters/directors form an integral part of the means of finance, it should be assumed that they would not be withdrawn during the currency of the loan and do not carry interest higher than that payable on institutional loans. Preliminary expenses incurred by the promoter are included in promoters contribution. It is important that no gap is left in financing patterns. Otherwise it will result in delays in implementation of the project. A condition is stipulated by financial institutions that the promoters shall arrange for funds to meet any over run in the cost of the project. While the emphasis of the financial institution is on the viability of the project they generally stipulate by way of security, a first legal charge on fixed assets of the company ranking pari passu with the charge if any, in favour of other financing institutions. e. Financial Projections For the purpose of determining the profitability of the project and the ability of the company to service its loans and give a reasonable return on the equity capital, estimates of cost of the project, profitability, cash flow and projected balance sheets have to be prepared in the proforma given for ten years. These are inter related and are prepared on the basis of the estimated cost of the project, sources of finance envisaged and various assumptions regarding capacity utilization, availability of inputs and their price trends and selling price. The important assumption that should be scrutinized carefully before making estimates are capacity build up, raw material cost, estimate of wages and salaries, cost of utilities, estimate of administrative expense, selling price assumed and provisions made for depreciation and statutory taxes. Verification of profitability is the core of proper appraisal of the project. The entrepreneur may be naturally tempted to present a bright picture but it is the task of financial appraisal to verify the estimates. It is to be ensured that the profits projected are realistic. In case of new units, any sharp build up of capacity within a year or two will be unwarranted especially if the product is new. The quantum of raw materials and utilities estimated to be consumed to obtain a particular quality/quantum of end product is the core of cost of manufacture estimates and should tally with the performance guarantees furnished by the collaborators/machinery suppliers. In case of multi product firms, the product mix is decided on the basis of contribution of each product, utilization of plant capacity as well as market. Annual increases in wages and salaries should be about 5 percent. Shilpa Bagaria / TYBBI/ Semester V 43 44. Project Finance Repairs and maintenance will have to be provided keeping in view the type of industry and the number of shifts to be worked. Depreciation of the fixed assets should be provided as per income tax rules. The selling price should be fixed keeping in view the present domestic price of the product. The profitability projections are closely linked to the schedule of implementation. On the basis of profitability projections, cash flow and projected balance sheets are prepared for a period of ten years. f. Evaluation of Cash Flow and Profitability Financial appraisal uses two popular methods and two discounted cash flow techniques to evaluate the cash flows and profitability of investment. The methods should have three properties to lead to consistently correct decisions. First, it should consider all cash flows over the entire life of a project; secondly, it should take into account the time value of money and finally it should help to choose a project from among mutually exclusive projects which maximize the value of the firms stock. 4. ECONOMIC APPRAISAL Aspects of Economic Appraisal Economic appraisal of a project deals with the impact of the project on economic aggregates. We may classify these under two broad categories. The first deals with the effect of the project on employment and foreign exchange and second deals with the impact of the project on net social benefits or welfare. a. Employment Effect While assessing the impact of a project on employment, the impact on unskilled and skilled labour has to be taken into account. Not only direct employment, but also indirect employment should be considered. Direct employment refers to the new employment opportunities created within the project and the first round of indirect employment concerns job opportunities created in projects related on input and output sides of the project under appraisal. b. Net Foreign Exchange Effect A project may be export oriented or reduce reliance on imports. In such cases an analysis of the effects of the project on balance of payments and import substitution is necessary. The assessment of project on the countrys foreign exchange is done in two stages; first, balance of payments effects of the project and second, import substitution Shilpa Bagaria / TYBBI/ Semester V 44 45. Project Finance effect of a project. The import substitution effect of a project measures the estimated savings in foreign exchange owing to the curtailment of imports of the items of production of which has been taken up by the project. The analysis of net foreign exchange effect may be done for the entire life of the project or on the basis of a normal year. If two or more projects are compared on the basis of their net foreign exchange effect, the annual figure should be discounted to their present value. c. Social Cost Benefit Analysis 1. Objectives Another aspect of economic appraisal is social cost benefit analysis. Cost benefit analysis is concerned with the examination of a project from the view point of maximization of net social benefit. While cost benefit analysis originated to evaluate public investment, it is also used in project appraisal. Earlier, project appraisal covered only private costs and benefits, at present, social costs and bene