POLITICALLY BACKED PROJECT FINANCING

SHAMSUL GHANI
(feedback@pgeconomist.com)
Mar 8 - 14, 2010

The bridge finance facility is misused in a number of cases, especially when projects are financed on political rather than real business considerations. A measure drawback is that the new entrepreneurs - or those who are not serious with the implementation of the project - avoid going for the IPO as they fear massive under-subscription and could hardly manage an underwriter. Strangely enough, the SBP regulations allowed the bridge finance to be treated as part of the equity. This is highly anomalous and heavily loaded in favour of the non-serious sponsors. It simply means that a project required to have a debt limit of 60 percent is allowed to operate with 80 percent debt burden and that too for a number of years.

The sponsors of most of the politically financed projects took advantage of this lacuna and abandoned the project through default after making quick buck. Their 20 percent equity investment normally came through low-cost agricultural land documented as high-price industrial land. The kickbacks from the suppliers of imported machinery were the icing on the cake.

The financial section of the project basically revolved around the financial assumptions the corporate finance mangers were required to develop. In fact these assumptions used to be already there in the feasibility submitted by the corporate client, but the corporate bankers put these assumptions to serious scrutiny and in the process the assumptions got changed drastically. The major assumptions related to company's sales projections, product unit cost and product unit price.

Other assumptions include: number of labor and supervisors, office staff, sales and marketing staff, executives etc. required for the project and the corresponding wages, salaries and remunerations. The accuracy of the major assumptions depends on the work carried out on the marketing side. Stern verification of company's claim for the market share of its product is necessary as major variance in the volume of sales could jeopardize the very viability of the project.

Intense market survey is also required to be taken by the corporate banker to ascertain the price level that the company product is likely to attain. The components of product cost should also be put under the scanner. The sustained and easy availability of raw material, utilities and labour is to be ensured both under the existing and future conditions. A project requiring imported raw material needs special attention of corporate bankers as frequent changes in global conditions and government import policy could render the project inoperable.

The norm is to draw financial projections for the first 5 to 10 years of the project operations. The projected financial accounts that usually need to be drawn are: balance sheet, income statement and cash flow statement. Computer-based programs for drawing these statements are immensely helpful these days. Prior to computerization of banking and financial systems, these statements had to be drawn manually with the help of a calculator alone. It used to be a hell of a job for the corporate bankers then. Computer-based calculations are of great help for financial sensitivity analyses. These analyses check the project profitability under changing conditions, for example change in the volume of sales, price cuts, cost escalations, imposition of new taxes or withdrawal of certain monetary incentives as a result of change in the government policy. These analyses should be carried out pragmatically to check the elasticity of the project rather than to scare away the sponsors by showing them a horrible future scenario under changing conditions. The guiding principle should be the law of probability that decrees that all bad things should not happen together.

A negative change might well be offset by a simultaneous change for the better. Nevertheless, the sensitivity analysis is a good tool to detect vulnerable points of the project and the findings should be discussed with the sponsors who might come up with a valid counter argument or a practicable alternate solution. As a corporate financer, I remember a project when a not-so-profitable fruit juice project in Karachi was changed to an ice cream manufacturing unit as the sponsors had an established expertise in ice cream manufacturing and selling business.

The preparation of projected financial statements is followed by calculation of financial ratios both in line with the SBP prudential regulations and the standard financial sector practices. While these ratios reveal most of the financial aspects of the project, the real test of financial viability lies in the calculation of IRR - Internal Rate of Return. Prior to IRR calculation, such exercises are also carried out as calculation of payback period under which the number of years the project cash flows (profit before depreciation) will take to pay back the amount invested in the project are determined- and the project break even point - the point when the project operation costs will exactly equal the project profits. Although being quite relevant, these two exercises hardly confirm the financial viability so decisively as the IRR method does. The main objections made against the efficacy of the payback method are (i) it ignores the timing of the cash flows; (ii) it doesn't take into account the cash flows after the payback period; and (iii) it ignores the time value of money. The break even analysis is perhaps more relevant of the two as it predicts the stage when the project will start generating net profits.

The time value of money concept is more relevant to the present day financial management. IRR in case of project financing is calculated on the basis of this concept. Time value concept measures the value of future cash flows in today's rupee terms called present value. For example Rs.100 receivable after one year has a present value of Rs.86.96, if the going interest rate is assumed at 15 percent. Under IRR method, all cash flows from the project normally during the first 7-10 years of its operation- are taken and checked for a discount rate that will equate them with the total investment in the project. This discount rate is then compared against the average weighted cost of the capital. The average weighted cost of the capital is calculated by assuming a certain minimum rate of return to the shareholders and taking into account the actual borrowing rate. Given that a project is financed on the basis of 60/40 debt equity ratio, and assuming that the minimum return to the shareholders will be 10 percent and that the bank loan will carry a 15 percent interest rate, the average weighted cost of total capital-equity plus debt- will come to 13 percent. For a project to be financially viable, a minimum spread of 2-3 percent is the norm. This means that with 13 percent average weighted cost of the capital, the project should have at least an IRR of 15-16 percent. The higher the spread, the higher the financial viability of the project.