Question

What is project financing?  Describe the factors that make an investment suitable for project financing approach.  Discuss the difference between the project financing and the conventional direct financing and the advantages of using project financing approach.

Answer 1

Project financing is funding of large infrastructural projects, industrial projects. The loan structure in the case of project finance is such that the debt and equity created to finance the project is paid back by the cash flows of the project. Project lenders are given a lien on all of these assets and are able to assume control of a project if the project company has difficulties complying with the loan terms. So, these loans are provided by the sponsors not the basis of the credit worthiness of the sponsors but on the basis of the cash flows generated by the projects of the borrower.

The factors which make an investment suitable for project financing is :

• The size of the project
• the time period for which the funds are required
• the purpose for which the funda are required
• the ability of the business to grow and generate cash flows
• the level of profits and reserves with the business.

Project financing is done purely on he basis fo the expected future cash flows generated by the project. These loans are secured against the property of the project .The loans are paid completely from the project cash flow and if the parties default to pay back the loan, then the project properties are being seized. To do the whole process properly, a special purpose entity is created for the entire project. Since, these financings are based on the projected cash flows of the project, the sponsor needs to make a thorough cash flow forecast to ascertain the future prospects of investing in the project.

The corporate finance approach :

Equity financing : In equity financing, the equity shareholders invest major of the funds in the company and in return they by a certain number of shares .

Working capital : the money from the day to day operations of the business is called working capital management. When the current assets is more than current liabilities then the working capital is positive and vice versa.

A business can fund money form IPO and also borrow from creditors.

Difference between project finance and corporate finance:

In corporate financing, the sponsor looks for revenue, corporate financing is much more riskier than project financing. The investors look into the balance sheet before investing in contrast to the financial modelling approach used by the investors in corporate finance approach.

The advantages of project financing is :

• taking the route of project financing also helps maintain confidentiality helps maintain a competitive advantage ove the competitors.
• in a project finance, due to the finite life of a project there is no conflict of interest between the management and the shareholders of the company.
• In project finance, the business can choose to not disclose the debt obtained in the balance sheet and use a special purpose vehicle . Use a special purpose vehicle /entity to finance a large project helps obtain funds without putting a large firm at risk. Project finance also permits the sponsors to share the project risks with other stakeholders.