Why Companies Prefer Project Finance to Corporate Finance

Literature Review

Companies have started opting for project finance rather than the corporate finance since the past few years. According to Inadomi (2010), project financing is an excellent mean of financing when it comes to avoidance of the record for the project debt on the balance sheet. Furthermore, it is, by far, an ideal way through which the sponsors evade the restrictions imposed on them in the loan documents. Many sponsors embrace project financing when their own capacity of borrowing or crediting is not much (Inadomi, 2010, p.318). The most prominent use of project finance is seen in the private sector whose governments do not involve much of the foreign exchange.

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Turner and Simister (2000) suggest the engineering of own operate transfer (BOOT). This entails that the project has its own financial package, with each project as a unique entity (Turner & Simister, 2000, p.542). According to Merna and Nijiru (2002), every project is different and has its own entity; hence special project vehicles (SPV) are made (Merna, & Nijiru, 2002, p.6). The banks offer loans to special project vehicles which are based on the limited or non availability of resource. This means that the loans are dependent upon the revenue which is brought in by the SPV’s. The assets of these SPV’s are termed as ‘collateral’. There could be many sponsors of the SPV; however, this does not entitle them to any other assets other than the project itself.

According to Vishwanath (2007), corporate finance is the one of the most common methods of acquiring loans from an organization. This loan sanction is backed by the balance sheet of the organization and is not limited to just one project. The people who want to give the project take deep interest in the organization’s balance sheet regarding its worth for sanctioning or lending a project. This is due to the fact that they have complete conviction that even if the project is not successful they will not lose their money and it will eventually be repaid. Lessard (2005) states that Oil companies typically see corporate finance in the cases of offshore drilling. These companies always are the ones who have very strong balance sheets.

Merna and Nijru (2002) are of the opinion that project financing is the term that is used when, for the arrangement of the loan, the repayment depends upon the cash flow that is generated at the end of project execution and also the projects’ interests, assets and all rights are held as collateral. According to Brealey (2007), corporate finance is relatively used for bringing funds together for various projects. The most important function of it is capital budgeting.

Gatti (2007) studied a recent increase in the project finance option. He stated that from the year 1994 through 2004 alone, there has been a 24% increase in the loans for the project finance, summing up to about 5 % of all the syndicated loans in the market. Even though it is still not well known and sought after topic in the academia, various factors that are involved in the pursuit of the project finance over corporate finance are discussed by Esty (2004). One factor is that the lenders are responsible for the future of the project and second is that ‘cash’ is everything. This means that the lender needs to be as much satisfied as the sponsor for returns on the capital.

Merna and Nijiru (2002) claim that the project finance involves two major things which are as follows:

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Features of project Finance

Special project Vehicle

Merging of the SPVs is the initial step of the project financing. In other words, a completely separate company is used which has nothing to do with the organization that is promoting it. This company operates with the help of concession which is usually granted by the government. Seed equity capital is provided by the sponsors of the company of the project for the SPVs which are almost always highly geared.

Non resource or limited resource funding

Loan is provided to the sponsor in order to enable him to get along with the project. This loan is termed as ‘non- recourse’. Fight (2006) argues that the sponsor is free of any liability to make the payment if the project is not successful and cannot generate much revenue in the form of profit. Also the lender looks at other means for indirect payment to cover the associated risks during project failures. These are usually the guarantees and the warranties that are acquired from the third parties involved in the project.

In essence, the funding in which the project lenders have no claim to any of the assets or the resources of the project lenders is termed as the non-resource funding, contradictory to the limited resource funding. This means that the assets of the sponsor are made accessible. These assets are however general assets and are accessible; there is guarantee of repayment as well as the condition holds true only for certain risks.

This increases the confidence of the project lenders since the project company is only involved with the activities that are specific in relation to the project only. Moreover, project lenders feel safe that there would be no liabilities associated or loss for that matter as the activities are bound only to project. Merna & Njiru, (2002) argue that the lenders also feel secure with this kind of funding as they can use their rights to replace the management that is not working according to them. Sometimes it is often written in the clauses project lenders can use their rights to even sell the project if they consider it as a failed project before its completion.

This further enables them to gain confidence in the sense that no matter what, they can recover their assets at any instance of time. On the other hand, the investors are at a disadvantage because they are, in this scenario, left with unfinished capacity which has no residual value. In the opinion of Klompjan and Wouters (2002), the lenders need to lay confidence in the project capacity and therefore need to meet the equity liabilities and debt. Moreover, it becomes inherent for them to show enough profits resulting from the project so that the sponsors remain interested.

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Off balance sheet transaction

According to Merna & Njiru (2002), off-balance sheet transaction is the opportunity that project finance presents the financers. This means that they can easily fund a given project outside the balance sheet. This is particularly beneficial in the case where the sponsors are shy of showing their general assets or cannot borrow funds because their assets are not strong.

Project finance is used mostly in the countries that are showing rapid development. It is usually used to fund projects like transportation, power, and telecommunication. It is a favorite amongst the industrialized countries.

The most common example of the project finance is seen in the USA, for the power plants. Brealey (2007) insists that the risks involved in this are not much as compared to a scenario where one company integrates with another, like for example, if the electric utility company was to construct a cogeneration plant with the integration of an industrial company, the electricity would be utilized by the electric company and the waste heat by the industrial plant. Hence, the guarantee of the revenue stream is driven by the utility. In such cases, banks are only too happy to lend even 90% of the total revenue for the project as they are assured of the cash flow.

Brealey (2007) suggests that the lenders who are experienced enough in project finance show greater willingness in taking more risky projects at hand. With this in mind, these experienced lenders go about by the reduction of the amount they lend and try to look for a way out of any other parent resource in case of a default.

However, according to Gatti (2007), there are many factors stating why project finance is chosen over corporate finance in high profile projects. These reasons are that in project finance, the guarantee of financing is determined by the project assets, whereas in the corporate finance, the guarantee of the assets in given by the assets of the borrower. The second factor is the variables that are existent behind the grant of the finance. In project finance these are the future cash flows whereas in corporate finance it is the profits, customer relation, and the solid balance sheet. Another factor is the degree of leverage that can be made to use.

For this, in project finance, the dependency lies with the cash flow that the project produces, while in the corporate finance, it is entirely dependent upon the balance sheet of the borrower. There is either no effect or very little effect on the sponsors when financial elasticity effect is accounted for the project finance. According to Williamson (1998), the financial elasticity in corporate finance is substantially reduced for the borrower. The accounting treatment in case of corporate finance is the off-balance sheet with dis-imbursement effect on the equity subscription in the SPV. Daly (1969) states that in corporate finance the accounting treatment is demonstrated on the balance sheet.

Inadomi (2007) argues that project finance is considered for high profile projects companies typically undertake because it creates additional costs and higher transaction costs. This creates an additional chance to increase the efficiency. Veron and Laconetti (2001), argue that the sponsors take a preference for project finance because of the greater profits associated with the avoidance of the supply. After making the investment decision, sponsors can alter the cost and benefit analysis. They are further assured of the increase in the safety in regards to the political risk. The only instance in which the sponsors might think of losing all these benefits is when they are pressurized by the market.

Foreshaw (1999) believes that project finance is ideal when the funding is required for specific investment within specific industries. Investments that are capital intensive infrastructures are more inclined toward project finance. These infrastructure investments produce stable income returns by the use of good technology. However, where the risk is high and there is doubt about the returns, it is not the obvious choice. It is therefore not used for research and development projects. Further, it is also not used for the advertisement of projects or for purpose of introducing a new product in the market.

Fight (2006) advocates that in short, project finance is not used for the intangible investments rather it is used for the tangible investments. Bigger projects where state-of-the-art technology is used and where the construction risks are known and calculated, the choice is often made as project finance. Kleimeier and Megginson (2000) argue that many companies take up adopt project finance because they feel that it is a gateway through which the allocation of the risks could be achieved. For example, risks like price, operation, revenue, political and completion are taken care of by individuals and professionals that can best manage them. The project finance is good in the aspect that it restrains the government from the seizure of cash that is generated once the project is rolling. Instead the cash flow is used in paying off the debt loans.

The key players of the Project finance

According to Winch (2010), primary players of project finance are the project sponsors. The sponsors are responsible for the investment in the special purpose vehicle. Then there are the engineering and the construction companies that actually engineer and construct the project. Some of the key players are the banks who are responsible for lending loans, the arranging banks that organize funding of the loan, the risk assessment professionals, and the financial and accounting professionals that control the risk evaluation risks involved in the project. Wibowo and Kochendorfer (2005) are of the opinion that all the legal specialists are responsible for the drawing up of the contract as well as for the distribution of responsibilities and risk allocation of the project.

Nonetheless, Inadomi (2010) argues that the government’s role in project finance is quite significant relative to all other forms of private funding. The major investments in project finance are funded in separate ways and also organized independently. SPV discretion is minimized over the cash flow. In contrast to this, corporate finance is characterized by provision of funding for the limited liability corporations. Discretion is maintained about the internal capital investment. New Vehicle Company is made in the event of project finance whose life is limited for every new investment.

Marrison (2010) points out three instances in which project finance is seen to be used. Firstly, sponsors select project finance in case where the political risk is high. The example for this is the pipeline project of Africa that spreads over the neighboring countries as well. Secondly, project finance is chosen in cases when the sponsors’ balance sheet is not too strong. In such a case, the sponsors are already acknowledging the risk involved as well as its expensive solution. Hence in this instance, project finance aids in increasing the funds even though the balance sheet of the sponsor is not supportive of a project. Lastly, whenever there is lesser market exposure, project finance becomes the obvious choice. These are the public private partnerships.

On the other hand, Lynch (1996) asserts that the non-recourse project finance has a direct bearing upon the sponsor’s cost benefit analysis. In the case when something goes wrong, the debt financing responsibility is shifted from the cost side of the investment decision. This in turn will result in the shift of the completion costs to the power purchaser with the market risk of zero. In this way the potential utility of the sponsor is elevated with the selection of the project finance.

Ahmed et al (1999) argue that the advantages of project finance over corporate finance are that it reduces the risks amongst all those who are involved with the project thereby making the risk bearable; it also increases the finance availability. The main difference is that in project finance, the sponsor can expand the business by increasing the leverage. The areas where corporate finance is beneficial to the company’s development are when the transfer of ownership is required or where there is need to accumulate heavy funds.

According to Turner and Simister (2000), project finance is embraced by several organizations nowadays since it does not involve their balance sheets. Most of the times, they are required to have strong balance sheets. Where the political risk is high the companies take up the option of project finance. For bigger project, project finance is the ideal choice as the construction risks are calculated as well as the technology that is used for the project is dependable and established.

To conclude, it is always up to the sponsors and the lenders to have a preference for project finance or corporate finance as is seen by the different attributing factors discussed in the Literature review. The studies conducted by various authors and the opinions delivered, were analyzed to determine the preference of the project finance over corporate finance.

Capital Structure theory

In the event where the firms are facing taxes and bankruptcy costs a model is applied for optimal capital structure and debt capacity. In the event of bankruptcy it was observed that the organization reached their debt capacities before the percetaged debt of 100%. The optimal capital structure theory bridges the value, leverage and risk together. Furthermore firms at a higher risk often choose higher debts when they are running smoothly at an equilibrium pace.

Project Finance Model

Project finance model
Fig 1: Project finance model (Estry, 1999).

References

Ahmed, P. A. (1999) Project Finance in developing countries. USA, World Bank Publications.

Brealey, R, A. Cooper, I. A. & Habib, M.A. (1996) Using project finance to fund infrastructure investments. Journal of Applied corporate Finance, 9(3),pp. 25-39.

Brealey, R. A. (2007) Principles of corporate finance. India, Tata McGraw Hill education.

Daly, G.G, (1969) The burden of the debt and future generations in local finance. Southern Economic Journal, 36(1), pp. 44-51.

Esty, B.C. (2004) Why study large projects?An introduction to research on project finance. European financial management, 10(2), pp. 213-224.

Estry, B. C. (1999) Petrozuata: A case study of the effective use of project finance, Journal of applied corporate finance, 12(3), p.p 26-42.

Fight, A. (2006) Introduction to project Finance. USA, Butterworth-Heinemann.

Gatti, S. (2007) Project finance in theory and practice: designing structuring and financing private and public project. USA, Academic Press.

Inadomi, H. M. (2010) Independent power projects in developing countries: legal investment protection and consequences for development. USA, Kluwer law International.

Kleimeier,S. & Megginson, W. L. (2000) Are product Finance Loans different from other syndicated credits?’, Journal of applied corporate finance. 13 (1), pp. 75-85.

Klompjan, R. & Wouters, M.J.F. (2002) Default risk in project finance. The journal of structured finance, 8(3), pp. 10-21.

Lessard, D.R. (2005) Incorporating country risk in the valuation of offshore projects. Journal of applied corporate finance, 9(3), pp. 52-63.

Lynch, P. (1996) Financial modeling for project finance. London, Euromoney Books.

Marrison,C. (2001) Risk management for project finance guarantees. The journal of structured finance, 7(2), pp. 45-53.

Merna, T & Njiru. C. (2002) Financing infrastructure projects. London, Thomas Telford.

Turner, J. R & Simister, S. J. (2000) Gower handbook of project management. England, Gower Publishing Limited.

Veron, E. L. & Laconetti, L.D. (2001) The Brave new world of U.S. power project finance. The journal of structured finance, 7(1), pp. 5-13.

Vishwanath, S. R. (2007) Corporate Finance: Theory and Practice. India, SAGE.

Williamson, O. E. (1998) Corporate finance and corporate governance. The journal of finance, 43(3), pp. 567.

Winch, G. M. (2010) Managing construction projects. USA, John Wiley and sons.

Wibowo, A. & Kochendorfer, B. (2005) Financial risk analysis of project finance in Indonesian Toll Roads. Journal of construction engineering and management, 131(9), p6.

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