THE FINANCING OF PROJECTS
This chapter describes the nancing of projects. No project can take place without fund-ing, and yet the raising of nance is something most project managers do not getinvolved in. However, the nancing can have a huge inuence on their project, and soproject managers do need to contribute to the development of the nancial strategy fortheir project, which in itself is a vital element of the overall project strategy.
The chapter is titled The Financing of Projects, rather than Project Finance. Thevast majority of projects are paid for by the parent organization, out of revenue expenditure,as in the case of maintenance or research projects, or out of capital expenditure, as in thecase of new investments. The capital is raised from the sources of nance described in theTypes and Sources of Finance section, based on the reputation of the parent organization, andsecured against its assets. The parent organization needs to repay the nance independentof the success or failure of the project. A few, usually large projects are nanced as entitiesin their own right. This is called unsecured, nonrecourse, or off-balance-sheet nancing. Itis unsecured because it is only secured against the projects assets and its revenue stream.If the project fails, the lenders have no recourse against which to recover their money. It isoff-balance-sheet, because if a parent organization invests in a project in this way, the capitalinvested does not appear in the companys balance sheet. Limited-recourse nancing is amixture of nonrecourse and recourse nancing, where the parent organization invests someequity in the project, which will appear on its balance sheet and will be lost in the event ofproject failure, but the majority of nance will be loans secured only against the projectsassets. Lenders prefer this because with some of their ownmoney invested in the project,the sponsor will have a greater interest in the success of the project. The term project nanceis usually reserved for nonrecourse or limited-recourse nancing. The other (usual) case isthe nancing of projects. This chapter considers both cases, and the sources of nance
The Wiley Guide to Managing Projects. Edited by Peter W. G. Morris and Jeffrey K. PintoCopyright 2004 John Wiley & Sons, Inc.
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described in Types and Sources of Finance section can be used for nancing the parent orga-nization or an individual project. However, the chapter mainly focuses on the second case.In the majority of projects, the money will be made available by the parent organization.In this case, money may be borrowed to nance a specic project, but it will be guaranteedagainst other assets of the parent organization, and so will be available at lower interestrates and will appear on the companys balance sheet. The role of the project manager,champion, or sponsor is to justify the expenditure using investment appraisal techniques,(Aston and Turner, 1995; Lock, 2000; Akalu, 2001). It is only in the case of non- or limited-recourse nancing that the project team will be involved in developing a nancial packagespecically for the project and approaching the nancial markets to nance the project.
The nancing of projects, including project nance, is a vast subject; whole books aredevoted to the subject. Thus, in the limited space of a single chapter, we can only focus ona number of key issues. The next section begins by explaining characteristics of projectnance. Then sources of nance are described. These sources are broadly the same for boththe parent organization and individual projects. Types of nance are considered, and con-ventional and unconventional sources of those different types described. The next sectiondescribes project nance, the nancing of individual projects on an unsecured, nonrecoursebasis. Finally, the process of creating a nancial package for a project to meet the investmentneeds while responding to the risk is considered.
Characteristics of the Financing of Projects
There are a number of features of the nancing of projects that affect the design of aparticular nancial strategy. Some of these features relate to the nancing of all projects;the latter ones refer more specically to project nance. The features include the following:
Finance is the largest single cost on a project. There is no project without nance. Financial planning begins at feasibility. The projects involved are often complex. Financial planning adds to project complexity.
Largest Single Cost
Finance is often the largest single cost on a project. On a large construction project, thematerial costs may be 30 percent of the total capital cost, construction costs 30 percent, anddesign, project management, commissioning, working capital, and contingency about 10percent each. On the other hand, on a project that takes two years to build, on the day itis commissioned, the total cost of the nancial package (interest paid to providers of debtand returns to equity holders) may amount to 20 percent, and 60 percent by the time thedebt has been paid off. Finance is therefore twice as much as the next largest cost. Oninfrastructure costs taking longer to build, they will be even larger. Thus, the nancial costs
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may be almost as great as the project costs, and so good nancial management is at leastas important as good project management.
This may not be obvious to many project managers, especially on projects nanced bythe parent organization, because the cost of project nance is not included in the estimate.It is allowed for in the investment appraisal process through the discount factor applied (seeAston and Turner, 1995; Lock, 2000; Akalu, 2001). Unfortunately, this may create distor-tions. Decisions will be made to minimize the capital cost, not minimize the nancial costor total cost. Usually, lower capital cost leads to lower nancial cost. But sequencing thecash ow can make a difference. A lower capital cost solution with the expenditure front-loaded in the project may have higher nance charges than a higher capital cost solutionwith expenditure later in the project. Whole-life costing techniques are being developed toaddress this problem. For nonrecourse nancing, the nanciers and nancial agents will bemore concerned with optimizing the cash ows to minimize nancial costs.
No Project without Finance
Consider three projects: the rst one has the design package complete, but only 90 percentof the nance has been sourced; on the second both the design package and the nancialpackage are 95 percent complete; and on the third, the design package is 90 percent nished,but the nancial package is totally in place. Only the third project can receive the go-aheadto begin. No project can begin without the nancial package in place. Yet many projectmanagers will focus on design completion and almost ignore the need for the nancialpackage. On projects nanced by the parent organization, preparing the design packagemay be part of the investment appraisal process, and so there is no nance until the designpackage is complete. However, for nonrecourse nancing, it may be necessary to obtainnance before design can start, and the nanciers may want to inuence the design solutionadopted, preferring less risky solutions.
Financial Planning in the Feasibility Study
For this reason, nancial planning for a project should begin at the same time as thetechnical solution or earlier. Regrettably, it is often begun at the last minute, when mostother features are already determined. The most successful projects are ones in which thenancial planning is a key part of the project strategy from the start and the aim of theproject is to minimize the whole-life cost, including the nancing charges and technicalsolutions adopted considering their impact on the nancial solution. The lenders, whetherthe parent organization or external nanciers, may have a view about which options shouldbe selected. They may have a view about which options minimize the risk and thereforeprovide the safest haven for their money. They may not want the projects promoter tochoose what appears to be the best value for the promoter or champion, but instead theone that provides the best value for them (the lenders), taking account of the risks. It istherefore useful to engage the nanciers as early as possible, so options are not selected thathave to be rejected.
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Problems with complexity will be particularly the case with projects using project nance,because they have several features that will make them especially complex:
They will usually be very large. They may cross national boundaries. They often exceed the capacity of a single organization to plan, supply, and construct. They are technically complex, demanding skills not widely available. They are dedicated to a single purpose, a major project rather than a program. They are located at remote sites. They take place over long timescales, with the return on investment often taking decades.
Financial Planning Adds Complexity
Projects requiring project nance tend to be complex, but the nance planning adds to thecomplexity. Three issues that need to be emphasized, because they exert signicant inuenceon the nancial planning:
1. The sources of nance need to be identied before the technical specication of theequipment. The nancial package often imposes a sense of compromise. But further,the lenders will impose constraint as to the level of risk they are willing to bear andmay indeed look for higher rates of interest with higher-risk technical solutions.
2. The structuring and acceptability of the nancial package is different from the perspec-tive of lender and borrower. Each will take a different perspective of the risk, each givinga different emphasis to the risks and the compromises involved. The lenders may wanthigher returns for certain risks, and thus it is sensible to take account of their concernsin the projects feasibility and planning stages.
3. However, if you do involve the lenders early, be aware that the availability of nanceand the terms on which it is available can be subject to signicant and rapid change,for reasons beyond the control of the project sponsor or project manager. The impactof these changes needs to be tracked throughout the feasibility and planning of theproject.
Types and Sources of Finance
This section considers types of nance and their sources. These types and sources may beused by the parent organization to nance itself, or they may be used in non- or limited-recourse nancing to nance the individual project
Types of Finance
There are two main types of nance: equity and debt.
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Equity. Equity is money subscribed by investors or shareholders. The shareholders get returnsfrom dividends and capital growth in the value of their equity. With equity, there is noguarantee that a dividend will ever be paid, nor that the money itself will ever be repaid.A dividend can only be paid after the interest and scheduled repayments of loans have beenpaid. And the equity can only be drawn out of the company or venture after all the obli-gations to the providers of debt have been met. If the project performs badly, the providersof equity may receive nothing, but if it performs well, the returns may be huge. Because ofthe higher risks involved, the providers of equity expect higher returns on average than theproviders of debt.
Mezzanine Debt. Mezzanine, or subordinate, debt is loans made by the holders of equity. It issometimes treated as equity, especially in the calculation of debt/equity ratios and so is alsosometimes called quasi-equity. It differs from equity in that it is repayable against a scheduleof payments and the returns to investors are in the form of interest payments at a prede-termined rate. However, those interest payments and scheduled repayments can only bemade after all the obligations to the providers of senior debt have been met. Thus, mez-zanine debt is higher risk that senior debt and so commands higher interest rates. Mezzaninedebt can take the form of debentures, preferred stocks, and other instruments.
Senior Debt. Senior debt is money borrowed from a number of possible sources but particu-larly banks. It is repayable against agreed schedules of payment, including the predeterminedinterest payments. Senior debt must be repaid before all other forms of nance (hence, thename), and the providers of senior debt have the rst claim on all assets of the venture ifthe borrower goes into liquidation. Debt can take the form of loans, bonds, and noncon-vertible debentures. It can also take the form of equipment provided under supply contractswith repayment to be made over the life of the plant. There are two types of senior debt:
1. Secured debt. This is debt secured against assets or collateral easily convertible to cash. Itmust almost by denition be money lent to the parent organization, secured against itsassets, and is repayable regardless of the performance of any projects for which it isintended. It commands a lower interest rate than unsecured debtthe interest rate onlybeing dependent on the reputation of the parent organization and the security of itsassets.
2. Unsecured debt. This is debt lent for a specic project, secured only against the assets ofthe project and its predicted revenue streams. It is unsecured, nonrecourse, off-balance-sheet project nancing. Given that it is dependent on the projects success, the interestrate will be higher than for secured debt and will be linked to the riskiness of the project.
Eurotunnel, the construction of the channel tunnel between England and France, was anexample of a limited-recourse nanced project, involving a mixture of debt and equity.Equity was provided by the project promoters, mainly contractors involved in the construc-tion of the tunnel, and by private investors. But the vast majority of the nance (in excessof 80 percent) was loans provided by banks. During construction of the tunnel, interest on
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the loans was added to the debt. But in the early stages, equity holders received some returnson their investment in that the share price steadily rose as the commissioning date, andhence the expected returns, became closer. In fact, the early revenue streams were notsufcient to cover the schedule of debt and interest payments to the banks. The shares nowhad no value, so the equity investors lost their investment, and the project effectively becamenonrecourse nance. But there was no point the banks foreclosing on their loans, becausethe hole in the ground (the projects main asset) had no value if it was not being used. Sothe banks converted much of their loans to equity, and are now receiving their returns overthe life of the project in the form of dividend payments.
Cost of Capital
Each form of nance has a cost associated with it: the cost of borrowi...