1、Project finance,Aditya Agarwal Sandeep Kaul Fuqua School of Business,Contents,The MM Proposition What is a Project? What is Project Finance? Project Structure Financing choices Real World Cases Project Finance: Valuation Issues The MM Proposition,The MM Proposition,“The Capital Structure is irreleva

2、nt as long as the firms investment decisions are taken as given” Then why do corporations: Set up independent companies to undertake mega projects and incur substantial transaction costs, e.g. Motorola-Iridium. Finance these companies with over 70% debt inspite of the projects typically having subst

3、antial risks and minimal tax shields, e.g. Iridium: very high technology risk and 15% marginal tax rate.,Contents,The MM Proposition What is a Project? What is Project Finance? Project Structure Financing choices Real World Cases Project Finance: Valuation Issues,What is a project?,High operating ma

4、rgins. Low to medium return on capital. Limited Life. Significant free cash flows. Few diversification opportunities. Asset specificity.,What is a project?,Projects have unique risks: Symmetric risks: Demand, price. Input/supply. Currency, interest rate, inflation. Reserve (stock) or throughput (flo

5、w). Asymmetric downside risks: Environmental. Creeping expropriation. Binary risks Technology failure. Direct expropriation. Counterparty failure Force majeure Regulatory risk,What does a Project need?,Customized capital structure/asset specific governance systems to minimize cash flow volatility an

6、d maximize firm value.,Contents,The MM Proposition What is a Project? What is Project Finance? Project Structure Financing choices Real World Cases Project Finance: Valuation Issues,What is Project Finance?,Project Finance involves a corporate sponsor investing in and owning a single purpose, indust

7、rial asset through a legally independent entity financed with non-recourse debt.,Project Finance An Overview,Outstanding Statistics Over $220bn of capital expenditure using project finance in 2001 $68bn in US capital expenditure Smaller than the $434bn corporate bonds market, $354bn asset backed sec

8、urities market and $242bn leasing market, but larger than the $38bn IPO and $38bn Venture capital market Some major deals: $4bn Chad-Cameroon pipeline project $6bn Iridium global satellite project $1.4bn aluminum smelter in Mozambique 900m A2 Road project in Poland,Total Project Finance Investment,O

9、verall 5-Year CAGR of 18% for private sector investment. Project Lending 5-Year CAGR of 23%.,Number of Projects,Lending by Type of Debt,Project Finance Lending by Sector,37% of overall lending in Power Projects, 27% in telecom. 5-Year CAGR for Power Projects: 25%, Oil strike price, k1 = D1. Junior d

10、ebt: face value = D2; strike price, k2 = D1+D2. Value of senior debt, V(D1) = V(riskless,D1) P(k1) Value of junior debt, V(D2) = V(riskless,k2) P(k2) V(D1) Value of total debt, V(D) = V(D1) + V(D2),Effect of Covenants on Debt Value,Management actions that result in risk shifting, increase equity val

11、ue (call) and decrease debt value (put): Bet the firm on a new technology that may have a small chance of success. Pay out large current dividends to shareholders. The future collateral of the firm will be reduced. Get new debt at the same seniority level and repurchase shares. Bank covenants to dea

12、l with such actions: New investment decisions need prior lender approval. “Cash Waterfall”: Pre-determine distribution of cash flows. Limitations on new debt and distribution to debtholders. Bank covenants limit managerial discretion and preserve value of debt.,Real Options: Generic Types,Real Optio

13、ns in Project Finance,Scale up: Are usually in the form of replication. These also include contractual real options in the form of leases etc. Affects project NPV. Switch up: Affects project NPV. Scope up: Affects value of Sponsors involvement. Study/start: Affects project NPV. Critical for stock ty

14、pe projects where precise estimation of reserves is critical to success.,Real Options in Project Finance,Scale down: Mostly applicable in the pre-completion stage. Scale down is rarely an option post-completion since projects are valuable almost exclusively as going concerns. Affects project NPV. Sw

15、itch down: Rarely an option for a project. Scope down: Similar to the scale down option. Flexibility option: The option to switch input or output mix is key to projects and can help reduce cash flow volatility. Affects project NPV.,Real Options: Industry Examples,Automobile: Recently GM delayed its

16、investment in a new Cavalier and switched its resources into producing more SUVs. Aircraft Manufacturers: Parallel development of cargo plane designs created the option to choose the more profitable design at a later date. Oil Refineries have the option to change their mix of outputs among heating o

17、il, diesel, unleaded gasoline and petrochemicals depending on their individual sale prices. Telecom: Lay down extra fiber as option on future bandwidth needs,Real Options: Industry Examples,Real Estate: Multipurpose buildings (hotels, apartments, etc.) that can be easily reconfigured create the opti

18、on to benefit from changes in real estate trends. Utilities: Developing generating plants fired by oil & coal creates the option to reduce input costs by switching to lower cost inputs. Airlines: Aircraft manufacturers may grant the airlines contractual options to deliver aircraft. These contracts s

19、pecify short lead times for delivery (once the option is exercised) and fixed purchase prices.,Real Options: Valuation Approaches,Black Scholes formula: The PV of cash flows is asset price and the variation in returns is volatility. It is difficult to find real world situations which fulfill assumpt

20、ions underlying the BSM. Binomial Option Pricing model: The most illustrative method. Have to incorporate varying risks of cash flows at each decision node. It is better to risk adjust the cash flows and use a risk free rate. Monte Carlo Simulation: The most robust and accurate method. Easy to integ

21、rate multiple and interacting real options. Can be used to accurately value an option when multiple options are present by comparing the analysis results with and without the option.,The MM Proposition,M&M premise of Structure irrelevance No transaction Costs No taxes No cost of Financial Distress N

22、o agency conflict No asymmetric Information,Real World situations Very high transaction costs that can affect the investment decision. Taxes are mostly positive and high and results in valuable tax shields. Capital and governance structure decreases risk thereby decreasing cost of distress. Behavior of various parties can be controlled through structure. Type and sequence of financing can improve inf