Project finance

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

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),


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- 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.


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


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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.


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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).


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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


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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


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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


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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.


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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.


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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 CONTRACTS1. 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 clé 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.


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- 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'achèvement), - 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.


- 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.


- 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.


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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 DOCUMENTS1. 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, -


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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 :


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- 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")


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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. Coverage’s 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.


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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 promoter’s 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


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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:


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§ 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.


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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.


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.


Project Finance

Tasks of the Project Manager

The project manager’s 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.


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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


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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.


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Tasks of Project Manager in Pre- Operation andOperation 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


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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


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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


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accounting, costing and record keeping. Although the debt-equity ratio and the

promoter’s 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


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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


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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 CWhere 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 = R 1 + R 2 + … + R n - I (1+ r) (1+ r) ² (1+ r) ⁿ

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 = 0where 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


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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.


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


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


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


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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


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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


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,


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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


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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


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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 project’s 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


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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 promoter’s contribution in the project is 22.5 percent of project

cost with a lower contribution for projects promoted by technical entrepreneurs. Normally


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the promoter’s 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 promoter’s 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.


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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 firm’s 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 country’s foreign exchange is done in two

stages; first, balance of payments effects of the project and second, import substitution


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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 benefits are also reckoned.

Cost benefit appraisal of a project proposes to describe and quantify the

social advantages and disadvantages of a policy in terms of a common monetary unit. An

enterprise or project adopting cost benefit analysis approach has, as its objective function,

net benefits to society whereas the objective function of a private project is net private

benefit or profit. Net social benefit entails that gains and losses be valued in a common

unit. The unit should reflect society’s strength of preference for each outcome. The

economist uses as a measure of this preference, the consumer’s willingness to pay (WTP)

for a good. This will be reflected in the price he pays, though not fully.

In many cases the prices are not observable or are distorted. In these

circumstances cost benefit analysis must seek surrogate prices or shadow prices to measure

what would the society be willing to pay if there is a market? Net social benefits are found

by deducting from benefits (WTP) compensation required (cost). Maximization of net

benefit should be finally equivalent to the maximization of social utility or social welfare.

Social costs and benefits and private costs and benefits differ because of market

imperfections, externalities and income distribution

2. Market Imperfections

Private costs and profits reflect social costs and benefits only under perfect

competition. Since markets were largely regulated and prices were administered earlier in

our country, resources used by private sector were under priced. The recent phenomenon of


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deregulation which has freed several resource prices from control may lead in future to

near approximation of conditions in perfect competition. For instance, foreign exchange

rate is now determined by markets. Since 1991, the interest on debentures is not fixed by

government. In several markets regulation and administered prices are being lifted.

3. Externalities

The difference between private costs and benefits and social costs and

benefits arises mainly because of externalities. The divergence arises because of economic

effects a transaction has on third parties. The effects may be benefits or costs. A project, for

instance, when it creates infrastructural facilities like roads, the area adjacent may be

benefited. Such benefits are, however, not included in assessing the benefits arising out of

the project. Actually, such benefits are invariably under provided and subsidies may have

to be paid to ensure their provision. On the other hand, a project may have harmful

environmental effects. Such costs are not internalized and not paid for by consumers or

producer. As a result, costs are imposed on society which is not accounted for. The activity

in question may also be over-extended.

The problem of externalities relating to environmental effects received

impetus from the thesis propounded by World Bank that wise environmental policies may

often make poor countries less poor. Not only is sound environmental policy essential for

durable development but many of the policies that improve the environment will also

strengthen development. They are also powerfully re-distributive since it is often the poor

that suffer from environmental degradation.

The cure for poverty is development. Development may also cure some kinds

of pollution. Given the right technologies, developing countries can decouple some kinds

of pollution from economic growth with beneficial effects on the economy.

4. Redistribution

Strictly from the viewpoint of the project promoter or owner, it is of no

consequence as to how the projects benefits are distributed among society. But to society or

government, it is essential to have information as to who benefits from the investment in

various projects. For instance, industrial projects are put forward and promoted whether in

private or public sector to alleviate poverty and improve income distribution. Our entire

five year plan has poverty alleviation as their basic objective. It is however, not appreciated

that the provision opportunities through industrial projects cannot be availed of by the poor.

The poor are unskilled and illiterate and do not have the skills that factory type of


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employment demands. To benefit poor, the emphasis should be on provision of

opportunities through Grih Udyog or rural cooperatives and on repetitive tasks which

demand little skill, such as textile printing, assembly and agro-material processing. The

structure of investment should not be to elongate the productive process or make it indirect.

Our plans have not been able to relieve poverty because projects promoted are of the

factory type. They are not suitable for integrating poor into market oriented activity.

Social cost benefit analysis is a specialized subject.

Sources of Term Loans: Development Finance Institutions

1. Industrial Development Bank of India (IDBI)


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The Industrial Development Bank of India (IDBI) which was established in

July 1964 under and Act of Parliament is the principal financial institution for providing

credit and other facilities for development of industry. It also promotes or develops

industrial units, coordinates working of institutions engaged in financing, and assisting

development of such institutions. IDBI has been providing direct financial assistance to

large and medium industrial units and also helping small and medium industrial concerns

through banks and state level financial institutions. The IDBI 1964 provides for the

following functions to be performed by it:

(1) Coordinate the activities of the other financial institutions including

Commercial banks

(2) Supplement their resources by providing refinance to these institutions

(3) Plan and promote industries of key significance to the industrial structure

(4) Adopt and enforce a system of priorities in promoting further industrial

growth.

The activities of the IDBI related to provision of finance may be broadly divided into five

groups: (1) direct assistance to industrial concerns in the form of loans, underwriting, and

subscription to shares and debentures and guarantees; (2) refinancing of industrial loans

granted by banks and other financial institutions; (3) rediscounting of bills arising out of

sales of indigenous machinery on deferred payment basis; (4) finance for exports in the

form of direct loans and guarantees and buyers abroad in participation with commercial

banks and refinancing of medium term export credit granted by commercial banks; and

(5) assistance to other financial institutions by way of subscription to their shares and

bonds.

2. Industrial Credit and Investment Corporation of India

(ICICI)

Industrial Credit and Investment Corporation of India (ICICI) was established

on January 5, 1955, and commenced its operations on April 14, 1955. The main objective


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of ICICI was to encourage and assist industrial investment in the private sector. Under its

Memorandum of Association, the ICICI was to accomplish its main objective by providing

medium and long-term loans in rupees and foreign currency, investment in equities,

underwriting shares and debentures issues, guaranteeing loans from other private sources,

and by providing managerial and technical assistance to enterprises. The main purpose for

which ICICI assistance is available is for the purchase of capital assets in the form of land,

building, and machinery. The ICICI also assists in planning and execution of an investment

proposal even from the very early stage.

The ICICI does not quote standard terms for loans and other financial assistance. Each case

is considered on its merit and decisions are made in the light of the risks involved, the

prevailing condition and practices of financial institutions, and the cost of ICICI’s own

funds. According to the resources position, the composition of assistance has varied from

year to year. The forign currency loans constitute the major form assistance. In respect of

loans, a commitment charge at a marginal rate is levied on the undrawn portion of the loan.

Full interest accrues on the portions of the loan disbursed. Loans are granted for periods up

to 15 years.The rates of ICICI’s underwriting commission are notified in the letter of

underwriting.

Since ICICI provides a major portion of its assistance in the form of foreign

currency loans, the pattern of assistance displays weight age in favour of industries which

require greater foreign currency credit. Some of the major industries which have received

assistance from the ICICI are chemical and petro-chemical industry, fertilizers, metal and

metal products, machinery manufacturing, and electrical equipments.

Operating Aspects and Policies of Financial Institutions

The development banks and other term lending institutions have o perform

appraisal tasks before deciding whether the project is bankable and whether the required

finances can be sanctioned. The appraisal tasks basically include the verification of

assumptions relating to technology, market, organizational structure, financial viability, and


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economic viability. More specifically the activities in the appraisal process can be

described as follows: (1) technical analysis, to determine whether the specification of

technical parameters is realistic and optimal.

(2) Commercial analysis, to determine whether product specification and

marketing plan and organizational structure are soundly conceived.

(3) Financial analysis, to determine whether financial costs and returns are

properly estimated and whether the project is financially viable.

(4) Social profitability analysis, to determine whether a project is worthwhile

from the point of view of society.

Procedures for Sanctioning Financial Assistance

The basic inputs for the appraisal process are derived from the feasibility

report as well as the information supplied by the entrepreneur in the application form for

financial assistance. Thus, the formal process of getting the assistance from term lending

institutions begins with filling up the application form as well as completion of the

feasibility report. The procedure for getting the financial assistance from the all-India term

lending institutions can be divided into three stages: (1) Pre-sanction (2) Post-sanction up

to disbursement, and (3) Post-disbursement and follow-up

Stage I- Pre-Sanction (by IDBI, ICICI) (Fig.2)

Enquiry ↓ Calling preliminary information, if necessary ↓ Supply of questionnaire for preparing the application


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↓ Receipt of application for financial assistance ↓ Examining application as to its completeness and receipt of examination fee ↓ In the case of joint financing, ensuring that copies of applications also sent to other institutions ↓ Preparation of summary of applications and soliciting Approvals for processing ↓ Calling promoters for discussion, if required ↓ Calling for credit reports and making prior references to government, etc. ↓ Suggestion/discussion at inter-institutional meetings in the case of joint-financing ↓ Scrutinizing application and issuing questionnaire on technical and financing points arising out of the application ↓ Programming and carrying out site inspection ↓ Preparing appraisal report and memorandum to advisory committee ↓ Advising applicants to depute promoters/representatives

for giving additional information/clarification that might be required by the advisory committee ↓ Consideration by advisory committee ↓ Preparing minutes of advisory committee and board memo ↓ Consideration by Board of Directors ↓ Issuing letter of rejection in case the application is rejected by the Board

Stage II- Post-Sanction up to Disbursement (Fig.3)

Discussion with promoters on important conditions tobe stipulated including the tentative terms of conversion

of a portion of rupee loan into equity. Preparing andissuing letter of intent


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↓Making references to IDBI/Central Government for

approval of sanction, wherever necessary↓

Preparing and issuing draft loan agreement/draft letterof underwriting for approval

↓On approval by applicants board/shareholders/govt.authorities, engrossing loan agreement and sending

branch for execution by an appointment↓

Investigation of title↓

Compliance of terms and conditions and arrangementsand securing of various approvals by applicant

↓Examination of prospects

↓Consideration of terms and conversion of part of rupee

loan into equity capital at the meetings of seniorexecutives of the institutions

↓Deciding the terms of conversion of part of rupee loan

into equity capital at inter-institutional meetings↓

Verification of physical and financial progress↓

Issuing final letter of underwriting↓

Execution of legal mortgage deed, personal guarantee,and other documents and deposit of insurance cover

↓Sanction of interim loan against equitable mortgage

and execution of other relevant documents↓

Disbursement of installments of loan/issue ofguarantee/opening of letter of credit under sub-loans in foreign currency

Stage III- Post-Disbursement and Follow-up (Fig.4)

Collection of interest and Watching progress fromPrincipal of loan/ watching periodical progress


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timely payment of reportsinstallments against deferred payments guaranteed by the corporation

Conversion of loan into Appointment of nominee equity capital in case option directorsis exercised Analysis of balance sheets and working results

Payment of loan in full Periodical inspections

Satisfaction of mortgage Discussions with Representatives of Assisted concerns and Nominee directors by Way of follow- up

Operating Aspects of Financial Institutions

(1) Before filling up the prescribed application form, it is advisable that the

entrepreneur meets the senior officials of the financial institutions and has a very frank

discussion on the pros and cons of setting up a particular project.


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(2) Based on the discussions with the executives of the financial institutions the

entrepreneur should prepare a detailed project feasibility report.

(3) The application is then completed by the promoters/entrepreneur. The

application is considered completed if the entrepreneur has the required letter of intent,

clearance of the Capital Goods Committee for proposed import of equipment, and

clearance of the land allocated by the Government for setting up of the project.

(4) The application is then submitted to either one of the financial institutions or

to more than one institution.

(5) The receiving institution then makes a summary of the application as

received and along with its comments, puts it up for a preliminary view to the meeting of

the senior executives of all the institutions who meet once in a month.

(6) At the meeting one of the financial institutions (IDBI, IFCI, ICICI) is

appointed as the lead institution for carrying out the detailed scrutiny of the application.

(7) A team of officers with technical and financial background from the lead

institution is assigned the task of scrutiny of the application. They prepare a list of queries

on which further information is required. At the same time other financial institutions may

also send their list of queries to the lead financial institution. For this purpose the

entrepreneur should send copies of application forms to all the financial institutions to

avoid delay and bottleneck. The lead institution is not authorized to commit itself on behalf

of the other institutions and that each individual institution has the right to obtain any

information that it may desire, independent of the lead institution. The lead institution only

facilitates the entrepreneur so as to save time and labour.

(8) After the list of queries has been answered the representatives of the

entrepreneur are called for preliminary discussion.

(9) After the discussions, a site inspection is made jointly by the officers of all the

institutions to assess the location, level of development of the land, and the infrastructural

facilities available in the vicinity. A meeting may also be arranged with the local Electricity

Board, Municipality, etc. to assess the availability of utilities in the area.

(10) After the visit to the site, the institutional representatives hold discussions

with the applicant’s representatives at the project office, where details of the information

submitted at the time of application are expected to be readily available. To expedite the

matter, it is advisable that the applicant has the following information ready at the time of

visit by the officers:

(a) Certificate of Government approval.


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(b) Map indicating proposed land/site.

(c) Building and plant layout.

(d) Quotations of all the equipment suppliers.

(e) Detailed break- up of the proposed capital expenditure.

(f) Details of all the profitability assumptions.

(g) Any other detail regarding background of the promoters, management setup

and project details that have not been submitted along with the application but may be

required by the officers.

(11) Usually, the scope of the project, list of equipments, project cost, and

profitability estimates are finalized during the visit and tentative financial plan is also

worked out.

(12) The final decision regarding the financial aspects is taken by the

entrepreneur and the senior executives of the financial institutions.

(13) After a detailed scrutiny of all the information submitted by the applicant

and discussions with his representatives, the institutions officers prepare a full report of

their findings. This report, if necessary, may be put before a committee of experts.

(14) The lead institution prepares a memorandum and presents it either at the

Senior Executive Meeting (SEM) or at the Inter Institution Meeting (IIM) and at the

meeting each institution indicates the extent up to which it is willing to assist the company

and sharing so decided is communicated to the applicant by the lead institution, so that the

applicant can start follow- up action with the other institutions for their assistance.

(15) The memorandum placed at the SEM/ IIM is next placed before the Board/

Executive Committee of the lead institution to obtain legal sanction of the assistance. Some

of the other institutions obtain adequate copies of the memorandum from the lead

institution for placing before their own board while other institutions prefer to write out

their own memorandum for placing before their board. In the latter case, the applicant may

be called upon to submit some additional information.

(16) The all India financial institutions provide the following type of financial

assistance:

(a) Underwriting of shares/debentures

(b) Direct subscription to shares/debentures

(c) Guarantee to equipment suppliers

(d) Long term loans


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(17) After the respective boards of the institutions approve assistance to the

applicant, a letter of intent is issued which in a sense conveys willingness of the institution

to provide the assistance, subject to the terms and conditions listed above. The letter of

intent is not, however, a legal document and does not bind the institution to grant

assistance.

(18) The next step is formal acceptance of the terms and conditions by way of a

letter. The institutions take up processing of legal formalities which include the following

points:

(a) Finalization of share issue prospectus.

(b) Examination of the title deeds for creation of security in the institutions favour.

(c) Other relevant matters.

(19) Each institution has is own list of approved solicitors who examine the title

deeds on its behalf and provide assistance.

(20) Disbursement: It sometimes happens that while the deeds of agreement have

been signed, certain terms and conditions are yet to be fulfilled, e.g. the formalities for

creation of the security are yet to be finalized. In these circumstances, the institutions agree

to make an interim disbursement.

(21) During the period of implementation, the assisted company is required to

keep the institutions posted about the progress of the project. To facilitate reporting, a

standard form has been designed by the all-India financial institutions which are just

gaining popularity. During the period of implementation, the institutional representatives

may sometimes visit the project site to assess the progress.

(22) Follow-up: Consequent upon the completion of the project, the institutions

keep in touch with the company until the loan is fully repaid or as the institution holds

shares in the company. The assisted company is required to submit information on its

working, every quarter, on the prescribed forms.

(23) In addition, it is incumbent upon the company during the currency of the

institutional assistance to obtain approval of the institutions for the following:

(a) Utilization of financial assistance from any organization.

(b) Creation of charge on any of its assets in favour of any other party.

(c) Issue of additional share capital in any form or manner.

(d) Change in the full-time director’s remuneration.


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Risk Minimization

Risk minimization lies at the heart of Project Finance. Project Finance is providing

finance for particular projects, which are later repaid from cash flows generated by those

specific projects.


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Risk Management

Risk Management is the process of Identification, Measurement, Monitoring and

Control and Mitigation of risks. Risk Management aims at Risk Minimization and not Risk

Elimination.

Risk

Risk is defined as a possibility of adverse impact on earnings and capital on account

of expected or unanticipated event. Risk and Time are opposite sides of same coin, for if

there were no tomorrow there would be any risk. Time transforms risk and the nature of

risk is shaped by time horizon.

Risk Minimization Process

Risk arises due to projects if not being completed on time or within the specified

budget, not operating to their full potential, or failing to generate sufficient revenues to

repay loans, or else getting terminated prematurely. To prevent the above events from

occurring and adversely affecting the project, a three step risk minimization process can be

implemented.

STEP ONE: RISK IDENTIFICATION AND ANALYSIS 1.Project sponsors can prepare a feasibility report, which is carefully reviewed by

financiers in consultation with experts.

2. Financiers particularly look at the correctness of cost estimation and the accuracy of

future cash flows.

3. Several financial models are then used to identify risks, which could affect the

repayment capacity of the project.

STEP TWO: RISK ALLOCATION

1. Risks, on identification, must be allocated to the appropriate parties who have the

financial ability to bear them.

2. Financiers look at allocating risks to such parties, who have an interest/stake in the

concerned project.


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STEP THREE: RISK MANAGEMENT

1. Project risks must be managed to minimize the probability of the risk event occurring.

2. To minimize the consequences in case if the event occurs.

3. The higher the risk involved, the greater the control that financiers have over the project.

Types of Risks

1. Completion Risk:

Design and Construction phase involves Completion risk.


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Completion risk involves the risk of not completing a project on schedule due to time,

budget, or technological constraints. Such events lead to delay in loan repayment and debt

accumulation.

To minimize risk before lending……..

a. Obtain completion guarantees from sponsors, requiring them to pay all debts if

completion is not on schedule.

b. Ensure significant financial interest of sponsors in the project to maintain their

commitment.

c. Ensure that the project is developed under the terms of fixed price and time, under the

supervision of reputed developers.

2. Resource Risk:

Operation Phase involves Resource risk- Risk of shortage of inputs to generate adequate

returns.

To minimize this kind of risk:

a. Experts reports must certify the existence of inputs.

b. Ensure long-term supply contracts for inputs as a protection against shortages or price

fluctuations.

c. Obtain guarantees for minimum input levels.

3. Operating Risks:

Operating risks are risks affecting cash flows and generation capacity of

projects, such as inefficiencies in operations, shortage of skilled labour etc.

Prior to lending, the risks can be minimized by ensuring that a reputed and

financially sound operator is in charge of the project.

During the loan period, detailed operations showing the utilization of acquired funds

should be prepared. This helps ensure that the funds are being utilized for permitted

operating costs only.

4. Market/Off Take Risks:

Market/Off Take Risk is a type of risk of not finding a buyer at the fixed price

to generate adequate cash flows.


Project Finance

This kind of risk is minimized by entering into a forward sales contract with a

financially sound company.

5. Credit Risks:

Credit risk involves the repayment capacity of the borrower. This kind of risk

could be minimized if the financier obtains a certificate of satisfaction with regard to

experience, personnel, and financial soundness.

6. Technical Risks:

Technical risk involves the risk of technical difficulties in construction and

operation of the projects plant. It can be minimized by mostly adopting new proven

technologies.

7. Currency Risks:

Currency Risks involves depreciation in loan and revenue currencies causing

an increase in costs and decrease in cash flows. This risk can be minimized by entering into

suitable hedging contracts, matching the currencies of supply contracts.

8. Approval and Political Risks:

Approval and Political Risk involves political and economic instability. Also,

affect on the project due to events causing political instability. By adhering to the law and

complying with necessary procedures these risks can be minimized.

STATE BANK OF INDIA (SBI)


http://www.statebankofindia.com/index.htm?lang=0&id=0

Project Finance

STATE BANK OF INDIA is the largest bank in India. It is also measured by the

number of branch offices and employees, the largest bank in the world. With an asset base

of $126 billion and its reach, it is a regional banking behemoth. It has laid emphasis on

reducing the huge manpower through golden handshake schemes and computerizing its

operation

HISTORY OF SBI

State bank of India are traceable to the first decade of 19 th century, when the

bank of Calcutta, later renamed as bank of Bengal, was established on 2nd june 1806. It

remains the oldest commercial bank in Indian subcontinent and also the most successful

one providing various domestic, international and NRI products and services, through its

vast network in India and overseas.

The RBI, which is the central banking organization of India, in the year 1955,

acquired a controlling interest in the imperial bank of India and the imperial bank of India

was christened on 30yh April 1955 as the state bank of India. This acquisition of the

controlling interest was done pursuant to the provision of the state bank of India act 1955,

an act enacted by the parliament of India.

GROWTH OF SBI

State bank of India has often acted as a guarantor to the Indian

governments, most notably during Chandra Shekhars tenure as prime minister of India.

With more than 9400 branches and a further 4000 + associate bank branches, the SBI has

extensive coverage. State bank of India has electronically networked most of its branches.

The bank has one of the largest ATM network in the region. The state bank of India has

had steady growth over its history, though it was marred by the Harshad Mehta scam in

1992. In recent years, the bank has sought to expand its overseas operations by buying

foreign banks. It the only Indian bank to feature in the top 100 world banks in the fortune

global 500 rating and various other rankings. According to the Forbes 2000 listing its tops

all Indian companies.

SBI TODAY


Project Finance

Today, state bank of India has spread its arms around the world and has a network

of branches spanning all time zones. SBIs international banking group delivers the full

range of cross border finance solutions through its four wings- the domestic divisions, the

foreign office division, the foreign department and the international service division.

Questionnaire on Project Finance


http://www.statebankofindia.com/index.htm?lang=0&id=0

Project Finance

1] What are the interest rate options on SBI project term loans?

Ans. The bank offers term loans with both fixed and floating rate options, customized to

the risk merits of the project as well as the promoter. Pricing is generally linked to the

bank’s medium term prime lending rate (MTLR), the lowest in the industry.

2] What additional facilities are there on these loans to optimize credit cost?

Ans. SBI project finance can be structured as either foreign currency or rupee loans with

option of conversion from one type to the other at the end of interest periods. This will help

to take advantage of forex fluctuations and global interest rate trends vis-à-vis domestic

rates to minimize the debt cost.

3] What are project term loan tenors like?

Ans. Project finance is typically structured as long term loans, with tenors generally from 5

to 10 years. Maturity periods and repayment modes are structured in line with the specific

aspects of each project and industry, factoring in a timeframe for the venture to generate a

stable revenue stream.

4] How is the repayment scheduled?

Ans. Repayment options are again structured in tune with the specific requirements of each

project and its promoter. Repayments can be periodic or bullet, or may come with an initial

moratorium during part of the project gestation period. For example, a seven-year loan may

have a moratorium on repayments during the first two years and the payment installments

may be spaced out during the remaining five years.

5] What is the SBI deferred payment guarantee?

Ans. SBI can extend deferred payment guarantees to industrial projects for obtaining

imported equipment. The Deferred Payment Guarantee is a standby credit guaranteeing

deferred payments, usually for payments for capital goods, turnkey contracts etc.

Survey Form of Project Finance

SHRI CHIANI COLLEGE OF COMMERCE & ECONOMICS

Survey for Project on Project Finance


Project Finance

NAME:DESIGNATION:

SIGNATURE: CONTACT NO:

1) Are you aware of Project Finance ?

Yes No

2) Have you taken any finance for your project?

Yes No

3) Do you think the procedure for Project Finance is?

Convenient Lengthy

4) Which bank would you like to prefer for taking finance for Projects? Private Public Foreign

5) What type of interest rate would you prefer?

Fixed Flexible

Comments:

Project Guide: Prof. Nishikant Jha Survey conducted by:Signature: Shilpa Bagaria T.Y.B.B.I. Roll No: 05

Survey Report On Project Finance

1) Are you aware of Project Finance ?


Project Finance

Options : Yes No

Yes

No

2) Have you taken any finance for your project?

Options: Yes No

3) Do you think procedure for project finance is?

Options: Convenient Lengthy


Project Finance

Convenient

Lengthy

4) Which bank would you like to prefer for taking finance for projects?

Options: Private Public Foreign

Private

Public

Foreign

5) What type of interest rate would you prefer?

Options : Fixed Flexible

Fixed

Flexible

Conclusion


Project Finance

Project Finance gives a brief overview of the common risks and methods of risk

minimization employed by financiers in project finance transactions. As stated previously,

each project financing is different. Each project gives rise to its own unique risks and hence

poses its own unique challenges. In every case, the parties - and those advising them - need

to act creatively to meet those challenges and to effectively and efficiently minimize the

risks embodied in the project in order to ensure that the project financing will be a success.

.


Project Finance

Bibliography

1. I referred to a book naming “Project Finance” by author “H.R. Machiraju”

2. I referred also to a book naming “Project Planning, Financing, Implementation, and

Evaluation” by “U.K. Srivastava”

3. www.google.com

4. www.statebankofindia.com


Project Finance


Project Finance


Economy & Finance

Project finance