Presentation on Project Finance

Mr. Aditya Dasgupta

Owner, Principal Consultant

Total Package Project Associates

Mumbai

INTRODUCTIONWith a view to harnessing advancements in economic development, Government of India laid emphasis on industrialization through successive Five Year Plans.

Rapid industrial development needed massive investment.

Prior to independence, there were no institutional arrangements for term finance.

INTRODUCTIONGovernment of India, therefore, established the following financial institutions:

Indl. Finance Corporation of India (1948)

Indl. Credit & Inv. Corpn. of India (1955)

Indl. Development Bank of India (1964) &

Indl. Reconstruction Bank of India (1971)

Similarly, State Governments also established SFCs in their respective states.

INTRODUCTION

For long, commercial banks confined their lendings to meet WC requirements only and they did not play any active role in extending term finance.

However, with increasing proportion of Term Deposits in their deposit portfolio and the paucity of resources in the country, it was felt that banks could enter the field of term finance, in a role complementary to that of Term Lending Institutions.

PROJECT BACKGROUNDThe purpose of term assistance is to meet a part of the capital expenditure of a project.

A project can be defined as ‘A scheme of things to be done during a specified period in future for deriving expected benefits under certain assumed conditions’.

A project may be in the nature of setting up a new industrial unit, modernisation, expansion, diversification and promotion of R&D.

PROJECT BACKGROUND

To set up a project, certain capital expenditure needs to be incurred in acquiring assets such as L&B, P&M and other infrastructural facilities like roads, water supply, railway sidings, etc., in addition to the Preliminary / Pre-Operative Expenses and margin on WC Limits.

Where promoters of a project are unable to meet the entire capital expenditure out of their own resources, Term Loans are sanctioned to supplement the promoters’ contribution.

PROJECT BACKGROUND

Promoters of an industrial project can constitute themselves into any of the following forms of business organizations to implement the project : Sole Proprietorship, JHF, Partnership, Co-operative Society & Joint Stock Company.

Our discussion of the subject would revolve around Joint Stock Company as promoter.

PROJECT BACKGROUNDThe Promotion Stage is a crucial stage in the entire life cycle of a project. Promotion in relation to a project will comprise broadly the following functions:

I] Identification of a project

II] Feasibility investigation

III] Assembling the proposition

IV] Financing the proposition

I] Identification of a ProjectThe first step in the project promotion is the identification of a project. An industrial project originates as an idea in a promoter when he observes the existence of a potential market for a certain product.

The promoter, on the basis of his experience, background and ability, then considers the feasibility of manufacturing and marketing the product at a remunerative price.

There should be an unsatisfied demand.

II] Feasibility InvestigationA detailed feasibility study is a costly exercise. It is, therefore, desirable that, before it is undertaken, marketability of the product to be manufactured is firmly established.

There are agencies, specialising in market research, which conduct such market studies. Promoters may take advantage of their services.

A market study aims at assessing the aggregate demand for a product.

II] Feasibility InvestigationThe promoter will now undertake the detailed feasibility investigation proper, comprising two feasibility studies:

i) The Technical Feasibility Study

ii) The Economic Feasibility Study

II] Feasibility Investigation- Technical Feasibility

Technical Feasibility Study covers the following aspects:

Location of the project

Lay-out of the Plant

Size of the Plant

Factory construction

Manufacturing process / Technology

Process Design

Product Design

Scale of Operation

Infrastructural facilities

II] Feasibility Investigation- Economic Feasibility

The prime objective of setting up a project is to derive a fair return on the investment.

Economic Feasibility Study, therefore, concerns itself with matching of economic resources with the physical requirements of a project and determining the viability of investment therein.

III] Assembling the Proposition- CoP & MoF

When a promoter is satisfied about the technical feasibility and economic viability of a project, the next task is to work out the Cost of the Project and the Means of financing it.

The Cost of the Project would broadly include: (a) L&B (b) P&M (c) Misc. Fixed Assets (d) Technical Know-how, Engg. & Consultancy fees (e) Preliminary and Pre-operative expenses (f) Provision for contingencies (g) Margin on WC Limits

IV] Financing the Proposition

Setting up of a project involves acquisition of Fixed Assets which facilitate the process of production. Fixed Assets have a relatively longer life and are generally not meant for resale. They are required to be retained over a period of time to exploit their productive potential.

C/A go through the operating cycle of RM, WIP and FG, which when sold bring in cash. This cycle is generally completed in a short period of less than one year.

IV] Financing the Proposition

Thus, investment in C/A is realized over a short term, while investment in Fixed Assets is long term in nature.

It is realized through surplus generated in the form of Net Profits, Depreciation and other non-cash write-offs.

As it takes a long time for the Fixed Assets to pay for themselves, the promoter should raise suitable long term funds to finance a project.

IV] Financing the Proposition

Keeping the foregoing in view, the promoter will explore the financial feasibility of the project by examining

a) The possible long term sources of finance

b) The feasible financial leverage

c) The expected return on the investment

IV] Financing the Proposition

Equity P referenc e

Share Capital Retained Earnings

OWNED CAPITAL

Debentures Term Loans, DPG s Public Deposits

BORROWED CAPITAL

LONG T ERM SOU RCES

IV] Financing the Proposition- Long Term Sources

The aggregate amount of finance raised for financing a project is referred to as Capital, comprising two components – (a) Owned Capital and (b) Borrowed Capital.

The other sources of long term funds are: (a) Capital Subsidy applicable to projects coming up in certain notified backward areas, and (b) Interest free sales tax loans offered by State Governments.

IV] Financing the Proposition - Financial Leverage

After considering availability of long terms sources of finance, the promoter will decide about a suitable financial structure for the Company.

It will depend upon the financial leverage envisaged in the combination of sources of finance under the two categories, viz., Owned Capital and Borrowed Capital.

Few projects can be financed entirely by equity or debt.

IV] Financing the Proposition - Financial Leverage

The divergent interests of debt and equity are brought into alignment by the concept of Debt / Equity gearing which determines the level of debt that can be supported by a given quantum of equity.

For this purpose, Debt means Funded Debt including all term liabilities and equity will include Share Capital and retained earnings, if available.

No standard D/E Ratio can be prescribed.

IV] Financing the Proposition- Return on Investment

The amount invested in a project can be recouped through annual cash flows, over a period of time.

In arriving at a financial plan for the project, a promoter will examine the attractiveness of the project, vis-à-vis alternative sources of investment.

The process which assists the management in such a task is collectively known as ‘Capital Investment Evaluation’.

IV] Financing the Proposition - Return on Investment

The most important and widely used Capital Investment Evaluation techniques are:

Pay-back Method

Net Terminal Surplus Method

Excess Present Value Method

Internal Rate of Return Method

IV] Financing the Proposition - Return on Investment

The object of Pay-back Method is to find out the period of time required for recovering the entire amount of investment made in a project.

The cash flows (Net Profit + Depreciation + Other non-cash write-offs) are compared with the outlay on the project to determine the pay-back period. Years to pay back would be:

Total Investment Cash Flow per annum

IV] Financing the Proposition - Return on Investment

Net Terminal Surplus Method employs the concept of compounding which involves re-investing the simple interest earned each year along with the principal so that the principal grows each year by the amount of interest earned during the previous year and interest being calculated on the increased principal also grows.

Future Value = Principal x (1+i)

IV] Financing the Proposition - Return on Investment

Excess Present Value Method is based on the discounted cash flow technique and uses the concept of discounting which is just the opposite of compounding.

In discounting, we arrive at the Present value of a future sum to which the original amount (which we want to find out), invested at a particular compound rate of interest has grown.

PV = Future sum (1+i)

IV] Financing the Proposition - Return on Investment

Internal Rate of Return Method – It is that rate at which the sum of the discounted cash flows is equal to the investment outlay. In other words, IRR is the rate which makes the Present Value (PV) of benefits equal to the Present Value of costs or reduces the Net Present Value (NPV) to zero. The object of this method is to find the rate of return which a project is likely to earn over its useful life.

IRR = Lower Discount Rate + Diff. Between the two discount rates x NPV at lower discount rate

Abs. diff. between the two NPVs.

Types of Term AssistanceThe types of term assistance extended by the Bank can be broadly classified into:

I] Term Loans (Incl. Forex Loans)

II] Deferred Payment Guarantees

III] Bill Discounting Facilities

IV] Underwriting of Shares / Debentures

Types of Term Assistance-Term Loan

A Term Loan is a loan granted for a fixed term of not less than one year, intended normally for financing fixed assets acquired / to be acquired, carrying interest at a specified rate, and scheduled for repayment in installments.

Depending on the term for which the said terms loans are granted, they could be classified into (a) Short Term Loans (b) Medium Term Loans and (c) Long Term Loans.

Types of Term Assistance-DPG

Deferred Payment Guarantee (DPG) is a contract to pay to the supplier the price of machinery, supplied by him on deferred terms, in agreed installments with stipulated interest on the respective due dates in case of default in payment thereof by the buyer.

A DPG is, in many respects, a substitute for a Term Loan and, as far as the buyer of P&M is concerned, it serves the same purposes as a Term Loan.

Standards of appraisal are the same as TL.

Types of Term Assistance- Bills Discounting

Under a contract for sale of machinery on deferred payment basis, the balance remaining to be paid after the initial down –payment represents the deferred receivables of the seller.

Thus, the funds of the seller get blocked for unduly long periods and the seller requires finance against such deferred receivables to replenish his Working Capital.

Types of Term Assistance - Bills Discounting

To facilitate availing of finance against the deferred receivables, the seller usually draws a series of usance bills with graded maturities to coincide with the due dates of payment of the relative installments (including applicable interest).

The usance bills drawn by the seller will be accepted by the buyer before they are discounted by the seller’s banker.

Types of Term Assistance- Underwriting of Shares

The necessity for underwriting arrangement arises only in the case of a Public Limited Company resorting to raise through the capital issue market, a part of the Share Capital for part-financing a project.

Underwriting is a contract whereby a person agrees, in consideration, to take up a specified number of shares or debentures or amount of debenture stock to be offered to the public, in the event of the public not subscribing for them.

Types of Term Assistance - Underwriting of Shares

Underwriting as a business will come under the scope of ‘Investment Banking’ as distinct from ‘Commercial Banking’.

In view of this, therefore, a high degree of selectivity should continue to be exercised in undertaking underwriting business.

However, the business stemmed not so much from the point of view of earnings on the investment as from the consideration that no viable project enjoying national priority should suffer for want of underwriting support.

Project Appraisal

The purpose of Project Appraisal is to ascertain whether the project will be sound – technically, economically, financially and managerially – and ultimately viable as a commercial proposition.

The appraisal of a project will involve the examination of:

a) Technical Feasibility : To determine the suitability of the technology selected and the adequacy of the technical investigation, and design.

Project Appraisalb) Economic Feasibility : To determine the conduciveness of economic parameters to setting up the project and their impact on the scale of operations.

c) Financial Feasibility : To determine the accuracy of cost estimates, suitability of the envisaged pattern of financing and general soundness of the capital structure.

d) Commercial Viability : To ascertain the extent of profitability of the project and its sufficiency in relation to the repayment obligations pertaining to term finance.

Project Appraisal

e) Managerial Competency : To ascertain that competent men are behind the project to ensure its successful implementation and efficient management after commencement of commercial production.

A project should also be examined, wherever appropriate, from the point of view of its value to the national economy in terms of socio-economic benefits like generation of employment opportunities, forex earnings, the quantum of import substitution, etc.

Project AppraisalThe first step in Project Appraisal is to find out whether the project is prima facie acceptable by examining salient features such as:

The background and experience of the applicants, particularly in the proposed line of activity

The potential demand for the product

The availability of the required inputs, utilities and other infrastructural facilities

Whether the project is in keeping with the priorities, if any, laid down by the Government.

Project Appraisal

The original application may not contain all the basic data / information. In such cases, it may be necessary to provide all the necessary data / information with a view to give an overall idea about the general feasibility of the project at the time of interview by the bankers.

After satisfying itself about the prima facie acceptability of the project, the Bankers will call for an prescribed ‘Application’, containing the following essential data / information, such as:

Project Appraisal

a) Particulars of the project along with a copy of the Project Report furnishing details of the technology, manufacturing process, availability of construction / production facilities, etc.

b) Estimates of cost of the project detailing the itemized assets acquired / to be acquired, inclusive of Preliminary / Pre-operative Expenses and WC margin requirements.

Project Appraisal

c) Details of the proposed means of financing indicating the extent of promoters’ contribution, the quantum of Share Capital to be raised by public issue, the composition of the borrowed capital portion with particulars of Term Loans, DPGs, Foreign Currency Loans, etc.

d) WC requirements at the peak level (i.e., when the level of Gross Current Assets is at the peak) during the first year of operations after the commencement of commercial production and the banking arrangements to be made for financing the WC requirements.

Project Appraisale) Project Implementation Schedule.

f) Organizational set up along with a list of Board of Directors and indicating the qualifications, experience and competence of (i) The key personnel to be in charge of implementation of the project during the construction period and (ii) The executives to be in charge of the functional areas of purchase, production, marketing and finance after commencement of commercial production.

Project Appraisalg) Demand projection based on the overall market prospects together with a copy of the market survey report.

h) Estimates of sales, CoP and profitability.

i) Projected P&L Account and B/S for the operating years during the currency of the Bank’s term assistance.

j) Proposed amortization schedule, i.e., repayment programme.

Project Appraisalk) Projected Funds Flow Statement covering both the construction period and the subsequent operating years during the currency of the Term Loan.

l) Details of the nature and value of the securities offered.

m) Consents from the Government / other authorities and any other relevant information.

Project AppraisalIn respect of existing concerns, in addition to this information, particulars regarding the history of the concern, its past performance, present financial position, etc., should also be called for.

The ‘Application’ completed in all respects and duly signed by the authorized signatories of the Company will form the basis for the detailed appraisal of the project.

Project Appraisal

An inspection of the project site (or factory in the case of existing units) will be done by the bankers.

Each project has to be examined in proper perspective having due regard to its nature, size and scope.

Although the basic techniques employed for appraising the viability of various projects are more or less the same, there could be no standard or uniform approach for appraising all projects.

Project AppraisalThe ultimate objective of the appraisal exercise is to ascertain the viability of a project with a view to ensuring the repayment of the borrower’s obligations under the Bank’s term assistance.

Therefore, it is not so much the quantum of the proposed term assistance as the prospects of its repayment that weighs with the bankers while appraising a project.

Project Appraisal

In project appraisal, nothing is assumed or taken for granted, so be truthful and give facts

All the data / information would be checked and, wherever possible, counter-checked through inter-firm and inter-industry comparisons.

It should be borne in mind that bankers believe “Healthy skepticism is a cardinal virtue in project appraisal.”

Project Appraisal Memorandum

1. PROPOSALNature of proposal;

Purpose : New project, expansion, modernisation, diversification or for any other approved purpose

2. BRIEF HISTORYBrief account of corporate history; MA & AA; Regd. address; Present organisational set up w ith BoD; Qualifications, experience and background;

L ine of activities, Financial position, etc., of Associate Concerns; Overall structure of inter-corporate investments

3. PAST PERFORMANCESummary of Company's past performance in terms of licensed / installed / operating capacities, sales, operating profit and Net Profit for

the past 3 years; Capacity utilisation; Sales & profitability; Dividend policy; Capital expenditure programmes implemented by the Companyduring the past 3 years and how they were financed; Company's management-labour relations

4. PRESENT FINANCIAL POSIT IONCompany's audited Balance Sheets & P/L Accounts for the past 3 years w ith analysis; Company's Capital structure; Summarise conclusions

of financial analysis; Method of depreciation; Revaluation of F/ A; Record of major defaults; Position of Company's tax assessment; ContingentL iabilities; Pending suits; Qualifications / Adverse remarks by auditors

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Project Appraisal Memorandum

5. PROJ ECT(a) Description of the project (Modernisation, expansion, diversification or a new venture) ; Standing, experience and reliability of

outside agency w ho prepared the Project Report; (b) Collaboration Arrangement (Technical or Financial); (c) Technical Feasibility coveringsuitability of technology, size & location of plant, technical arrangements & mfg. process (d) Financial Feasibility covering Cost of Project & Means of Finance

6. PROJ ECT IMPLEMENTAT ION SCHEDULEWith reference to Bar Chart or PERT / CPM Chart and in the light of actual implementation; Main stages in the project implementation and whether the time

schedule for construction, erection / installation of P&M, start-up / trial run, commencement of commercial production is reasonable & acceptable

7 . PRODUCT ION FACTORS(a) Mfg. Process - Basis of selection & justification; (b) Raw Materials - Imported / Indigenous, Names of main suppliers, Pattern of unit prices & fluctuation;

(c) Utilities & Essential Services - Requirements of power, fuel, w ater, transport, railw ay siding w ith comments on adequacy of arrangements, treatmentand disposal of effl uents; (d) Operating Organisation - Experience and expertise of Managerial / Technical personnel, other staff required

8. WORKING CAPITAL REQUIREMENTSAssessment of total WC requirements at the peak level (GCA) during the first year of operations after commencement of commercial production;

sharing of business among member banks; financing of additional WC requirments in case of ex isting companies

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Project Appraisal Memorandum

9. MARKETING(a) Sales prospects and underlying assumptions, demand projections on the basis of past consumption, total supply position, general condition of industry

(b) Selling Price - T rend to see whether stable, Govt. price controls, quota systems, etc.; (c) Propsects for exports - Export obligations;(d) Marketing Organisation - Adequacy, Distributors / Selling Agents, Terms of arrangement, remuneration, competence, Asso. Concerns - Siphoning of profits

10. COMMERCIAL VIABIL ITY - CoP & PROFITABIL ITY(A) Sales Volume / Value - (a) Volume; (b) No. of working days; (c) Capacity utilisation; (d) Value (B) CoP - (a) Matls. consumed; (b) Utilities (PW&F); (c) Wages & Salaries

(d) Factory Overheads; (e) Depreciation - SLM / WDV- Consistency; (f) Selling Exp.; (g) Financial Exp.; (h) Admn. Exp.; (i) Royalty & Know-how; (j ) Preliminary / Pre-operativeExp.; (k) Taxation (C) Profitability (CMA Data and ratios) (D) Inter-firm comparison

11. COMMERCIAL VIABIL ITY - DSCR & REPAYMENT PROGRAMME(a) DSCR (Gross) and (Net) ['Core Test' Ratio], Margin of safety and extent of risk coverage; (b) Break-Even Analysis - For first full year of production and

the year of maximum capacity utilisation; (c) Cost-Volume-Price (CVP) or Senstivity Analysis - For the year w ith operating profit nearest to the average operating profit todetermine 'Span of Resiliency' of the project; (d) Repayment Programme based on the above factors and in itial moratorium (start-up) period

12. FUNDS FLOW ANALYSISFunds Flows to be divided into Long Term Funds Flows and Short Term Funds Flows - Dif. would indicate Long Term Surplus or Deficit / Movements in C/A & OCL leading toincrease or decrease in WCG; Essential expenditure on F/ A, repayment obligations, taxes and dividends are fully provided for; Cash generation would be adequate to meet

all commitments during the entire repayment period.

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Project Appraisal Memorandum

13. PROJ ECTED BALANCE SHEETS(a) Projected B/ S covering the entire period of repayment to be scrutin ised; (b) CoP, MoF, Profitability estimates, Funds Flow projections and projected B/ S are all inter-related

(c) Projected B/ S to be scrutin ised analytically w ith reference to all other related essential data to ensure that all the projections, made realistically and accurately,have been woven into well co-ordinated financial statements.

14 . SECURITY & MARGIN AND RATE OF INTEREST(a) Complete details of security to be off ered for the Term Loan; (b) Detailed Opinion Report on guarantors; (c) Security Margin Coverage Ratio; (d) Whether security off ered

and the margin available are adequate and satisfactory (e) Credit Rating to be done and interest rate (Pricing) to be in line w ith this rating, unless market forces demandotherw ise

15 . SPECIAL TERMS & CONDIT IONS(a) Right of examination of borrow er's books; (b) Restriction w ith regard to change in Capital Structure; (c) Restriction w ith regard to (i) Repayment of deposits from F&Rw ithout the permission of the Bank (ii) Rate of interest payable on such deposits to be low er than the rate of interest charged by the Bank; (d) Restriction w ith regard to

transfer of controlling interest in the Co. or drastic change in the Company's management set-up w ithout Bank's prior permission; (e) Other standard T&C.

16 . ECONOMICS OF UNDERWRIT INGIn case of composite proposal, (a) Underw riting tie-up; (b) Capital Market trends; (c) Market response to the proposed public issue; (d) Lock-up of funds;

(e) Comparative Earnings Analysis - Underw riting Commission, Dividends, Capital Gains after Tax ; (f) Comparison of total earnings thus arrived at w ith total earnings thatw ould accrue to the Bank if the amount (Value of shares devolving) is lent by w ay of Term Loans for the same period

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Project Appraisal Memorandum

17. CONSENTS FROM GOVERNMENT AND OTHERSThese w ill relate, inter alia, to (a) Industrial Licence; (b) Approval for collaboration agreement and technical know-how arrangement; (c) Clearance for import of P&M;

(d) Approval for making payments for imported P&M on deferred terms and specific clearance for tax exemption on interest; (e) Consent from Controller of Capital Issues(f) Various approvals / No Objection Certificates from CG / SG / Local Authorities, etc. (g) Present position

18. GROUP COMPANIES(a) Brief resume of Group Companies indicating the extent to which they are dependent on the parent company / other companies in the Group; (b) Company's liability in

respect of partly paid shares in subsidiary companies

19. MANAGERIAL COMPETENCY(a) Company's management set-up; (b) Composition of the BoD; (c) CEO in charge of day-to-day aff airs of the Company; (d) Quality of the Company's management

and the level of managerial expertise built-up w ithin the Group; (e) Whether all departments are well served by professionals

20. OTHERS AND RECOMMENDATIONS(a) Verify RBI's List of Defaulters / Wilful Defaulters / Suit Filed Accounts; (b) Verify ECGC's Specific Approval List; (c) Indicate the IRR for the project and comments on

comparison w ith the IRRs for similar projects in the same industry; (d) Indicate the importance of the project in terms of national priority and impact thereon; (e) Detail thevalue of the Company / Group's connections to the Bank; (f) Whether, all considered, the proposal is a fair banking risk; (g) Recommendations for sanction of Term Loan.

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