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Precisely, Describe the Characteristics of Project Finance
Name
MSPM 6102 - Practices in Project Management
Walden University
2022
PRECISELY, DESCRIBE THE CHARACTERISTICS OF PROJECT FINANCE.
1.0 Introduction
1.1 Definition of Project Finance
Project finance is the long term financing of infrastructure and industrial projects based upon the
projected cash flows of the project rather than the balance sheets of the project sponsors.
2.0 Characteristics of Project Finance
Usually, a project financing structure involves a number of equity investors, known as sponsors,
as well as a syndicate of banks or other lending institutions that provide loans to the operation.
The loans are most commonly non-recourse loans, which are secured by the project assets and
paid entirely from project cash flow, rather than from the general assets or creditworthiness of
the project sponsors, a decision in part supported by financial modeling.
According to Freeman, (1982) the financing is typically secured by all of the project assets,
including the revenue-producing contracts. 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.
A salient characteristic in Project Finance is the cash flow waterfall contract which specifies
precisely how project cash flows may be used. Typically, the borrower will be required to use
project cash flows first in satisfaction of project operating expenses, and then to pay interests and
loan principals, Owen, (1999).
Furthermore, since project companies invest in single, discrete assets, trade-offs between
inefficient continuation versus inefficient liquidation that arise from the presence of future
growth opportunities and characterize the process of corporate bankruptcy Scharfstein, (1991)
are absent in Project Finance.
Project finance is capital-intensive. Project financings tend to be large-scale projects that require
a great deal of debt and equity capital, from hundreds of millions to billions of dollars.
Infrastructure projects tend to fill this category. A World Bank study in late 1993 found that the
average size of project financed infrastructure projects in developing countries was $440 million.
However, projects those were in the planning stages at that time had an average size $710
million.
The projects are highly leveraged. These transactions tend to be highly leveraged with debt
accounting for usually 65% to 80% of capital in relatively normal cases.
Project financing tend to be a Long term endeavor. The tenor for project financings can easily
reach 15 to 20 years. However, the tenor too depends on how intensive or huge the project is.
Smaller projects can take shorter time to be completed.
Project finance is an Independent entity with a finite life. Similar to the ancient voyage-to-
voyage financings, contemporary project financings frequently rely on a newly established legal
entity, known as the project company, which has the sole purpose of executing the project and
which has a finite life so it cannot outlive its original purpose. In many cases the clearly defined
conclusion of the project is the transfer of the project assets.
There’s is Non-recourse or limited recourse financing. The project company is the borrower.
Since these newly formed entities do not have their own credit or operating histories, it is
necessary for lenders to focus on the specific project’s cash flows. That is, “the financing is not
primarily dependent on the credit support of the sponsors or the value of the physical assets
involved. Thus, it takes an entirely different credit evaluation or investment decision process to
determine the potential risks and rewards of a project financing as opposed to a corporate
financing. In the former, lenders place a substantial degree of reliance on the performance of the
project itself. As a result, they will concern themselves closely with the feasibility of the project
and its sensitivity to the impact of potentially adverse factors. Lenders must work with engineers
to determine the technical and economic feasibility of the project. From the project sponsor’s
perspective, the advantage of project finance is that it represents a source of off-balance sheet
financing.
According to Rossi, (1982), in project financing, there is a Controlled dividend policy. To
support a borrower without a credit history in a highly-leveraged project with significant debt
service obligations, lenders demand receiving cash flows from the project as they are generated.
This aspect of project finance recalls the Devon silver mine example, where the merchant bank
had complete access to the mine’s output for one year. In more modern major corporate finance
parlance, the project has a strictly controlled dividend policy, though there are exceptions
because the dividends are subordinated to the loan payments. The project’s income goes to
servicing the debt, covering operating expenses and generating a return on the investors’ equity.
A project financing tend to have many participants. These transactions frequently demand the
participation of numerous international participants. It is not rare to find over ten parties playing
major roles in implementing the project. Reinvestment decision is removed from management’s
hands.
Project finance is a Single-purpose entity time horizon matches life of project
Corporate management makes decisions autonomous from investors and creditors
Fixed dividend policy - immediate payout; no reinvestment allowed
Capital investment decisions
Project finance is highly transparent to creditors in way that the are aware of what is the project
entails and the activities inconjuction with the progressing of the project.
Project finance has relatively higher costs due to documentation and longer gestation period Size
of financings Flexible Might require critical mass to cover high transaction costs Basis for credit
evaluation Overall financial health of corporate entity; focus on balance sheet and cash flow.
Finance projects has Technical and economic feasibility; focus on project’s assets, cash flow and
contractual arrangements, Cost of capital relatively lower relatively higher Investor/lender base
typically broader participation with deep secondary markets.
Other specific characteristics of project finance include the following;
i. A project is established as a separate company
ii. A major proportion of the equity of the project company is provided by the project
manager or sponsor, thereby tying the provision of finance to the management of the
project
iii. The project company enters into comprehensive contractual arrangements with suppliers
and customers
iv. The project company operates with a high ratio of debt to equity, with lenders having
only limited recourse to the equity-holders in the event of default.
v. Technical and economic feasibility; focus on project’s assets, cash flow and contractual
arrangements.
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