PROJECT FINANCING

SHAMSUL GHANI
(feedback@pgeconomist.com)

Mar
1 - 7, 2010

The financial section of a feasibility report deals with the estimated project cost and formulation of assumptions based on which financial projections for the next 5-10 years are drawn. Corporate banker should strive to critically examine the estimates that go into the calculation of the total project cost. Failure to do so may result in under financing or over financing of the project. In the former case, calculation of revised project cost and scaling up of financing commitments will be required. Undertaking of such exercises after the financial close always entails serious time and cost overruns. Financing commitments on both the bankers and the sponsors sides are not easy to scale up as either of the parties might find it difficult to commit further funds to the project.

Hypothetically, a typical manufacturing project sponsored by a public limited company might have the following cost and financing configurations.

TOTAL PROJECT COST AND CORRESPONDING MEANS OF FINANCING
(IN MILLION RUPEES)

A: PROJECT COST ESTIMATES B: FINANCING PLAN
PARTICULARS AMOUNT PARTICULARS AMOUNT
Land 4 Bank financing 60
Building and civil works 7
Imported plant & machinery 52
Import incidentals 10 Sponsors' equity 20
Local machinery & equipment 8
Furniture & fixture 2
Vehicles 7 Common shareholders' equity (through IPO) 20
Interest during construction period 2
Contingencies 3
Total Fixed Cost 95 Sponsoring directors' loan -
Permanent working capital 5
Total Project Cost 100 Total Financing 100

In case the project comes under one of the leading sectors of the economy, for example, textile, sugar, cement, energy etc, the verification of project cost items should not be difficult for the corporate banker as host of information about similar projects is available in the market. The origin and the cost of imported machinery should get the special attention of the banker. As already discussed, any variance vis--vis the market information should be seriously discussed with the sponsors of the project, and unless sufficiently convinced, the bankers should not compromise on these variances. In case of unusual and green seed projects, the corporate bankers have to be extra cautious.

As shown in the table, the imported machinery gets more than 50 percent of the cost allocations as industrial projects are normally capital intensive. The import incidentals refer to the taxes and duties, and can be easily verified from the relevant tariff structures. Import incidentals are capitalized and added to the cost of the imported machinery. "Interest during construction" is an illusive item in that failure to estimate it correctly might result in serious problems. This item is a function of the size of borrowed funds, the rate of interest for those funds and most importantly the completion time of the project. Feasibility estimates for the completion time are usually on the lower side, as the unforeseen delays in machinery import, completion of civil construction, erection of plant and machinery, trial runs, and start of commercial production are not properly taken into account. This results in higher interest costs during the construction period. Since all interests paid during the construction period are capitalized that is added to the original cost s of machinery and civil works, delays in project completion affect the profitability of the project as future depreciation expenses become higher. Contingencies are the estimates for some unforeseen cost escalations take may take place during the implementation phase. As a rule of thumb, these estimates represent a certain percentage of the total project cost.

Permanent working capital is that part of the total working capital that ever remains invested in the business. It is highly unlikely that an ongoing business attains a zero inventory level or, all of its credit sales are paid off at a particular point in time. Since the receivables and inventories never reach the zero point level, the permanent working capital estimates are required to be made at the project cost estimation stage for inclusion in the total project cost. Some standard methods to calculate the permanent working capital requirement are in vogue. These methods vary in line with the nature of business and can be made use of accordingly, both by the corporate borrowers and lenders.

Sources of financing of the project cost are basically determined by the SBP prescribed debt and equity ratio requirement. This ratio may vary according to the nature of the industry and the inherent level of capital intensiveness. A ratio of 60:40 is the norm in most of the cases meaning that maximum debt level could be 60 percent of the total project cost, or conversely, at least 40 per cent equity investment has to be made in the project. In addition to the equity requirement, there could be a rider, specifying the minimum level of sponsors' stake. In case of a public limited company, normally 50 percent of the paid up capital is contributed by the sponsors and their families/friends, while the remaining 50 percent is offered to the public in the shape of an IPO initial public offering. Hypothetically, for a particular project, the SBP requirement could be a debt equity ratio of 60:40 with sponsors' minimum stake of 25 percent. It means that in a project having a total cost estimate of 100 million, the sponsors will be required to invest at least 25 million. Since they can't invest more than 20 million in the share capital, the additional 5 millions will have to be invested in the shape of sponsoring directors' loan. This loan is normally ranked as "subordinated", which means that the business can't pay back the loan unless the claims of all other creditors are satisfied. In addition to the 60 percent debt, the sponsors could avail bridge finance equal to the amount of public issue till such time the company goes for public share floatation. This bridge finance is immediately paid off from the proceeds of the IPO.