Project Finance

Campbell R. Harvey Aditya Agarwal Sandeep Kaul

Duke University

Contents
The MM Proposition What is a Project? What is Project Finance? Project Structure Financing choices Real World Cases Project Finance: Valuation Issues

The MM Proposition
The Capital Structure is irrelevant as long as the firms investment decisions are taken as given Then why do corporations: Set up independent companies to undertake mega projects and incur substantial transaction costs, e.g. Motorola-Iridium. Finance these companies with over 70% debt even though the projects typically have substantial risks and minimal tax shields, e.g. Iridium: very high technology risk and 15% marginal tax rate.

Contents
The MM Proposition What is a Project? What is Project Finance? Project Structure Financing choices Real World Cases Project Finance: Valuation Issues

What is a Project?
High operating margins. Low to medium return on capital. Limited Life. Significant free cash flows. Few diversification opportunities. Asset specificity.

What is a Project?
Projects have unique risks:
Symmetric risks:
Demand, price. Input/supply. Currency, interest rate, inflation. Reserve (stock) or throughput (flow).

Asymmetric downside risks:

Environmental. Creeping expropriation.

Binary risks
Technology failure. Direct expropriation. Counterparty failure Force majeure Regulatory risk

What Does a Project Need?

Customized capital structure/asset specific governance systems to minimize cash flow volatility and maximize firm value.

Contents
The MM Proposition What is a Project? What is Project Finance? Project Structure Financing choices Real World Cases Project Finance: Valuation Issues

What is Project Finance?

Project Finance involves a corporate sponsor investing in and owning a single purpose, industrial asset through a legally independent entity financed with non-recourse debt.

Project Finance An Overview

Outstanding Statistics
Over $220bn of capital expenditure using project finance in 2001 $68bn in US capital expenditure Smaller than the $434bn corporate bonds market, $354bn asset backed securities market and $242bn leasing market, but larger than the $38bn IPO and $38bn Venture capital market

Some major deals:

$4bn Chad-Cameroon pipeline project $6bn Iridium global satellite project $1.4bn aluminum smelter in Mozambique 900m A2 Road project in Poland

Total Project Finance Investment

Total Project Finance Investment
250 200 150 Million USD 100 50 0 1997 1998 1999 Years 2000 2001 Equity Finance MLA/ BLA Bonds Bank loans

Overall 5-Year CAGR of 18% for private sector investment. Project Lending 5-Year CAGR of 23%.

Number of Projects
Number of Projects

700 600 500 Number of 400 Projects 300 200 100 0 1997 1998 1999 2000 2001 Years Project with Bond Finance Projects with Bank Loan Finance

Lending by Type of Debt

Percent Lending by type of debt
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1997 1998 1999 Years 2000 2001

Percentage

Bonds Bank Loans

Project Finance Lending by Sector

Amount of Project Lending by Sector
$120.00 $100.00 $80.00 Amount USD $60.00 $40.00 $20.00 $1997 1998 1999 2000 2001 Years Industrial Leisure Petrochemical Mining Telecom Oil and Gas Infrastructure Power

37% of overall lending in Power Projects, 27% in telecom. 5-Year CAGR for Power Projects: 25%, Oil & Gas:21% and Infrastructure: 22%.

Contents
The MM Proposition What is a Project? What is Project Finance? Project Structure Financing choices Real World Cases Project Finance: Valuation Issues

Project Structure
Structure highlights Comparison with other Financing Vehicles Disadvantages Motivations Alternative approach to Risk Mitigation

Structure Highlights
Independent, single purpose company formed to build and operate the project. Extensive contracting
As many as 15 parties in up to 1000 contracts. Contracts govern inputs, off take, construction and operation. Government contracts/concessions: one off or operate-transfer. Ancillary contracts include financial hedges, insurance for Force Majeure, etc.

Structure Highlights
Highly concentrated equity and debt ownership
One to three equity sponsors. Syndicate of banks and/or financial institutions provide credit. Governing Board comprised of mainly affiliated directors from sponsoring firms.

Extremely high debt levels

Mean debt of 70% and as high as nearly 100%. Balance of capital provided by sponsors in the form of equity or quasi equity (subordinated debt). Debt is non-recourse to the sponsors. Debt service depends exclusively on project revenues. Has higher spreads than corporate debt.

Comparison with Other Vehicles

Financing vehicle Secured debt Subsidiary debt Similarity Collaterized with a specific asset Dis-similarity Recourse to corporate assets Possible recourse to corporate balance sheet Collaterized and nonrecourse High debt levels Concentrated equity ownership Hold financial, not single purpose industrial asset No corporate sponsor Lower debt levels; managers are equity holders

Asset backed securities LBO / MBO Venture backed companies

Disadvantages of Project Financing

Often takes longer to structure than equivalent size corporate finance. Higher transaction costs due to creation of an independent entity. Can be up to 60bp Project debt is substantially more expensive (50-400 basis points) due to its non-recourse nature. Extensive contracting restricts managerial decision making. Project finance requires greater disclosure of proprietary information and strategic deals.

Motivations: Agency Costs

Problems:
High levels of free cash flow. Possible managerial mismanagement through wasteful expenditures and sub-optimal investments.

Structural solutions:
Traditional monitoring mechanisms such as takeover markets, staged financing, product markets absent. Reduce free cash flow through high debt service. Contracting reduces discretion. Cash Flow Waterfall: Pre existing mechanism for allocation of cash flows. Covers capex, maintenance expenditures, debt service, reserve accounts, shareholder distribution.

Motivations: Agency Costs

Problems:
High levels of free cash flow. Possible managerial mismanagement through wasteful expenditures and sub-optimal investments.

Structural solutions:
Concentrated equity ownership provides critical monitoring. Bank loans provide credit monitoring. Separate ownership: single cash flow stream, easier monitoring. Senior bank debt disgorges cash in early years. They also act as trip wires for managers.

Motivations: Agency Costs

Problems:
Opportunistic behavior by trading partners: hold up. Ex-ante reduction in expected returns.

Structural Solutions:
Vertical integration is effective in precluding opportunistic behavior but not at sharing risk (discussed later). Also, opportunities for vertical integration may be absent. Long term contracts such as supply and off take contracts: these are more effective mechanisms than spot market transactions and long term relationships.

Motivations: Agency Costs

Problems:
Opportunistic behavior by trading partners: hold up. Ex-ante reduction in expected returns.

Structural Solutions:
Joint ownership with related parties to share asset control and cash flow rights. This way counterparty incentives are aligned. Due to high debt level, appropriation of firm value by a partner results in costly default and transfer of ownership.

Motivations: Agency Costs

Problems:
Opportunistic behavior by host governments: expropriation. Either direct through asset seizure or creeping through increased tax/royalty. Exante increase in risk and required return.

Structural Solutions:
Since company is stand alone, acts of expropriation against it are highly visible to the world which detracts future investors. High leverage forces disgorging of excess cash leaving less on the table to be expropriated.

Motivations: Agency Costs

Problems:
Opportunistic behavior by host governments: expropriation. Either direct through asset seizure or creeping through increased tax/royalty. Exante increase in risk and required return.

Structural Solutions:
High leverage also reduces accounting profits thereby reducing local opposition to the company. Multilateral lenders involvement detracts governments from expropriating since these agencies are development lenders and lenders of last resort. However these agencies only lend to stand alone projects.

Motivations: Agency Costs

Problems:
Debt/Equity holder conflict in distribution of cash flows, reinvestment and restructuring during distress.

Structural Solutions:
Cash flow waterfall reduces managerial discretion and thus potential conflicts in distribution and re-investment. Given the nature of projects, investment opportunities are few and thus investment distortions/conflicts are negligible. Strong debt covenants allow both equity/debt holders to better monitor management.

Motivations: Agency Costs

Problems:
Debt/Equity holder conflict in distribution of cash flows, reinvestment and restructuring during distress.

Structural Solutions:
To facilitate restructuring, concentrated debt ownership is preferred, i.e. bank loans vs. bonds. Also less classes of debtors are preferred for speedy resolution. Usually subordinated debt is provided by sponsors: quasi equity.

Why Corporate Finance Cannot Deter Opportunistic Behavior ?

Do not allow joint ownership. Direct expropriation can occur without triggering default. Creeping expropriation is difficult to detect and highlight. Multi lateral lenders which help mitigate sovereign risk lend only to project companies. Non-recourse debt had tougher covenants than corporate debt and therefore enforces greater discipline. In the absence of a corporate safety net, the incentive to generate free cash is higher.

Motivations: Debt Overhang

Problems:
Under investment in Positive NPV projects at the sponsor firm due to limited corporate debt capacity. Equity is not a valid option due to agency or tax reasons. Fresh debt is limited by preexisting debt covenants.

Structural Solutions:
Non recourse debt in an independent entity allocates returns to new capital providers without any claims on the sponsors balance sheet. Preserves corporate debt capacity.

Motivations: Risk Contamination

Problems:
A high risk project can potentially drag a healthy corporation into distress. Short of actual failure, the risky project can increase cash flow volatility and reduce firm value. Conversely, a failing corporation can drag a healthy project along with it.

Structural Solutions:
Project financed investment exposes the corporation to losses only to the extent of its equity commitment, thereby reducing its distress costs. Through project financing, sponsors can share project risk with other sponsors. Pooling of capital reduces each providers distress cost due to the relatively smaller size of the investment and therefore the overall distress costs are reduced. This is an illustration of how structuring can enhance overall firm value. That, contradicting the MM Proposition.

Motivations: Risk Contamination

Structural Solutions: Problems:
A high risk project can potentially drag a healthy corporation into distress. Short of actual failure, the risky project can increase cash flow volatility and reduce firm value. Conversely, a failing corporation can drag a healthy project along with it. Co-insurance benefits are negative (increase in risk) when sponsor and project cash flows are strongly positively correlated. Separate incorporation eliminates increase in risk.

Motivations: Risk Mitigation

Completion and operational risk can be mitigated through extensive contracting. This will reduce cash flow volatility, increase firm value and increase debt capacity. Project size: very large projects can potentially destroy the company and thus induce managerial risk aversion. Project Finance can cure this (similar to the risk contamination motivation).

Motivations: Other
Tax: An independent company can avail of tax holidays. Location: Large projects in emerging markets cannot be financed by local equity due to supply constraints. Investment specific equity from foreign investors is either hard to get or expensive. Debt is the only option and project finance is the optimal structure. Heterogeneous partners:
Financially weak partner needs project finance to participate. It bears the cost of providing the project with the benefits of project finance. The bigger partner if using corporate finance can be seen as free-riding. The bigger partner is better equipped to negotiate terms with banks than the smaller partner and hence has to participate in project finance.

On or Off-Balance Sheet
Professor Ben Esty: Your question regarding on vs. off balance sheet is a good one, but not one with a simple answer. I do not know of a good place to refer you to either.

On or Off-Balance Sheet
The on/off balance sheet decision is mainly a function of both ownership and control. Project finance for a single sponsor with 100% equity ownership results in on-balance sheet treatment for reporting purposes. But....because the debt is a project obligation, the creditors do not have access to corporate assets or cash flows (the rating agencies view it as an "off credit" obligation--in other words, not a corporate obligation). Even though people refer to PF as "offbalance sheet financing" it can, as this example shows, appear on-balance sheet. A good example is my Calpine case where the company has financed lots of stand alone power plants. In the aggregate, the company showed D/TC = 95% on a consolidated basis.

On or Off-Balance Sheet
With less than 100% ownership, it gets a lot trickier. Many projects are done with 2 sponsors each at 50%. In this case, they both can usually get off-balance sheet treatment for the debt and the assets. Instead, they use the equity method of reporting the transaction (with even lower ownership, they use the cost method of reporting). All of this changes if they have "effective control" which is a very nebulous concept. (with 40% ownership but 5 out of 8 directors you might be deemed to have control). Even if you do not have to report the debt on a consolidated basis, there are often lots of obligations that do need to be disclosed. For example, if you agree to buy the output of a project, that should be disclosed as a contingent liability in the footnotes to your annual report. There are differences between tax and accounting conventions.

Alternative Approach to Risk Mitigation

Risk Completion Risk Price Risk Resource Risk Operating Risk Environmental Risk Technology Risk Solution Contractual guarantees from manufacturer, selecting vendors of repute. hedging Keeping adequate cushion in assessment. Making provisions, insurance. Insurance Expert evaluation and retention accounts.

Alternative Approach to Risk Mitigation

Political and Sovereign Risk Externalizing the project company by forming it abroad or using external law or jurisdiction External accounts for proceeds Political risk insurance (Expensive) Export Credit Guarantees Contractual sharing of political risk between lenders and external project sponsors Government or regulatory undertaking to cover policies on taxes, royalties, prices, monopolies, etc External guarantees or quasi guarantees Swaps and Hedging Credit Strength of Sponsor, Competence of management, good corporate governance Hedging

Interest Rate Risk Insolvency Risk Currency Risk

Contents
The MM Proposition What is a Project? What is Project Finance? Project Structure Financing choices Real World Cases Project Finance: Valuation Issues

Financing Choice
Portfolio Theory Options Theory Equity vs. Debt Type of Debt Sequencing

Financing Choice: Portfolio Theory

Combined cash flow variance (of project and sponsor) with joint financing increases with:
Relative size of the project. Project risk. Positive Cash flow correlation between sponsor and project.

Firm value decreases due to cost of financial distress which increases with combined variance. Project finance is preferred when joint financing (corporate finance) results in increased combined variance. Corporate finance is preferred when it results in lower combined variance due to diversification (co-insurance).

Financing Choice: Options Theory

Downside exposure of the project (underlying asset) can be reduced by buying a put option on the asset (written by the banks in the form of non-recourse debt). Put premium is paid in the form of higher interest and fees on loans. The underlying asset (project) and the option provides a payoff similar to that of call option.

Financing Choice: Options Theory

The put option is valuable only if the Sponsor might be able/willing to exercise the option. The sponsor may not want to avail of project finance (from an options perspective) because it cannot walk away from the project because:
It is in a pre-completion stage and the sponsor has provided a completion guarantee. If the project is part of a larger development. If the project represents a proprietary asset. If default would damage the firms reputation and ability to raise future capital.

Financing Choice: Options Theory

Derivatives are available for symmetric risks but not for binary risks, (things such as PRI are very expensive). Project finance (organizational form of risk management) is better equipped to handle such risks. Companies as sponsors of multiple independent projects: A portfolio of options is more valuable than an option on a portfolio.

Financing Choice: Equity vs. Debt

Reasons for high debt:
Agency costs of equity (managerial discretion, expropriation, etc.) are high. Agency costs of debt (debt overhang, risk shifting) are low due to less investment opportunities. Debt provides a governance mechanism.

Financing Choice: Type of Debt

Bank Loans:
Cheaper to issue. Tighter covenants and better monitoring. Easier to restructure during distress. Lower duration forces managers to disgorge cash early.

Project Bonds:
Lower interest rates (given good credit rating). Less covenants and more flexibility for future growth.

Agency Loans:
Reduce expropriation risk. Validate social aspects of the project.

Insider debt:
Reduce information asymmetry for future capital providers.

Financing Choice: Sequencing

Starting with equity: eliminate risk shifting, debt overhang and probability of distress (creditors requirement). Add insider debt (Quasi equity) before debt: reduces cost of information asymmetry. Large chunks vs. incremental debt: lower overall transaction costs. May result in negative arbitrage.

Contents
The MM Proposition What is a Project? What is Project Finance? Project Structure Financing choices Real World Cases Project Finance: Valuation Issues

Real World Cases

BP Amoco: Classic project finance Australia Japan cable: Classic project finance Polands A2 Motorway: Risk allocation Petrolera Zuata: Risk management Chad Cameroon: Multiple structures Calpine Corporation: Hybrid structure Iridium LLC: Structure and Financing choices Bulong Nickel Mine: Bad execution

Case : BP Amoco
Background: In 1999, BP-Amoco, the largest shareholder in AIOC, the
11 firm consortium formed to develop the Caspian oilfields in Azerbaijan had to decide the mode of financing for its share of the $8bn 2nd phase of the project. The first phase cost $1.9bn.

Issues:
Size of the project: $10bn. Political risk of investing in Azerbaijan, a new country. Risk of transporting the oil through unstable and hostile countries. Industry risks: price of oil and estimation of reserves. Financial risk: Asian crisis and Russian default.

Case: BP Amoco
Structural highlights:
Risk sharing: Increase the number of participants to 11 and decrease the relative exposure for each participant. Since partners are heterogeneous in financial size/capacity, use project finance. Sponsor profile: Get sponsors from major superpowers to detract hostile neighbors from acting opportunistically. Get IFC and EBRD (multilateral agencies) to participate in loan syndicate and reduce expropriation risk. Staged investment: 2nd phase ($8bn) depends on the outcome of the 1st phase investment. Improves information availability for the creditors and decreases cost of debt in the 2nd phase.

Case : Australia Japan Cable

Background: 12,500km cable from Sydney, Australia to Japan via Guam at
a cost of $520m. Key sponsors: Japan Telecom, Telstra and Teleglobe. Asset life of 15 years.

Key Issues:
limited growth potential Market risk from fast changing telecom market Risk from project delay Specialized use asset: Need to get buy in from landing stations and pre-sell capacity to address issue of Hold Up Significant Free Cash Flow

Case : Australia Japan Cable

Structural highlights:
Avoid Hold up Problem through governance structure: Long term contracts with landing stations. Joint equity ownership of asset with Telstra and landing station owners both as sponsors. High project leverage of 85% Concentrates ownership and reduces equity investment. Shares project risk with debt holders. Enforces contractual agreement by pre-allocating the revenue waterfall. Enforces Management discipline. Short term debt allow for early disgorging of cash.

Case : Polands A2 Motorway

Background: AWSA is an 18 firm consortium with
concession to build and operate toll road as part of ParisBerlin-Warsaw-Moscow transit system. Seeking financing for the 1bn deal (25% equity). Is being asked to put in additional 60-90m in equity. Concession due to expire in 6 weeks.

Key Issues:
Assessment of project risk and allocation of risks. How can project risk best be managed? Developing a structuring solution given the time pressure.

Case : Polands A2 Motorway

Structure for allocation of Risk
Construction Risk:
Best controlled by builder and government. Fixed priced turnkey contract with reputed builder. Government responsible for procedural delay and support infrastructure. Insurance against Force Majeure, adequate surplus for contingencies.

Operating Risk:
Best controlled by AWSA and the operating company. Multiple analyses by reputable entities for traffic volume and revenue projections. Comprehensive insurance against Force Majeure. Experienced operators, road layout deters misuse.

Case : Polands A2 Motorway

Structure for allocation of Risk
Political Risk:
Best controlled by Polish Government and AWSA. Assignment of revenue waterfall to government: Taxes, lease and profit sharing. Use of UK law, enforceable through Polish courts. Counter guarantees by government against building competing systems, ending concession.

Financial Risk:
Best controlled by Sponsor and lenders. Contracts in to mitigate exchange rate risk. Low senior debt, adequate reserves and debt coverage, flexible principle repayment. Control of waterfall by lenders gives better cash control. Limited floating rate debt with interest rate swaps for risk mitigation.

Case : Petrolera Zuata, Petrozuata C.A.

Background: $2.4bn oil field development project in Venezuela consisting
of oil wells, two pipelines and a refinery. It is sponsored by Conoco and Marvan who intend to raise a portion of the $1.5bn debt using project bonds.

Key Issues:
What should be the final capital structure to keep the project viable? What is the optimum debt instrument and will the debt remain investment grade? How can the project structure best address the associated risk?

Case : Petrolera Zuata, Petrozuata C.A.

Operational Risk Management
Pre Completion Risk
Includes resource, technological and completion risk. Resource and technology not a major factor ( 7.1% of resources consumed and proven technology). Sponsors guarantee to mitigate completion risk.

Post Completion Risk

Market risk and force majeure. Quantity risk is mitigated by off-take agreement with CONOCO. However price risk not addressed due to secure deal fundamentals.

Sovereign Risk
Key risk is of expropriation. Exchange rate volatility is a minor consideration. Fear of retaliatory action on expropriation. Government ownership of PDVSA.

Case : Petrolera Zuata, Petrozuata C.A.

Financial Risk and Capital Structure
Financial Risk: Optimum leverage at 60% for investment grade rating. Evaluation of Debt Alternatives BDA/ MDA: Reduced political insurance, and loan guarantees at higher cost and time delay. Uncovered Bank Debt: Greater withdrawal flexibility at a fee. Shorter maturity, size and structure restrictions, variable interest rate. 144A bond market: Longer term, fixed interest rates, fewer restrictions and larger size. Relatively new and negative carry. Equity returns: Equity can be adjusted within reason to get better rating.

Case : The Chad Cameroon Project

Background: An oil exploration project sponsored by Exxon-Mobil in
Central Africa with two components: Field system: Oil wells in Chad, cost: $1.5bn. Export System: Pipeline through Chad and Cameroon to the Atlantic, cost: $2.2bn.

Key Issues:
Chad is a very poor country ruled by President Deby, a warlord. Expropriation risk. Possibility of hold up by Cameroon. Allocation of proceeds World Banks role and Revenue Management Plan.

Case : The Chad Cameroon Project

Possible financing Strategies for Exxon-Mobil Financing Options Field System Export System Total Investment $3723m

Corporate Finance: 1 sponsor, EM 100% owner Corporate Finance: 3 Sponsors, EM 40% Owner Hybrid structure: 3 Sponsors, EM 40% owner

$1521m

$322m+$1881m=$220 3m 40%*($2203m) = $881m Project Finance 40%*(123+680)= $321m 16% * ($2203) =$352m

40%* $1521m = &608m Corp. Finance 40%* $1521m = $608m 16%*$1521m = $243m

$1489m

$929m

Project Finance: 3 sponsors D/V=60% EM 40% Owner

$596m

Case : The Chad Cameroon Project

Structural choice: Hybrid structure Brings in the World Bank to address the issue of Sovereign Risk. Exxon-Mobil chooses corporate finance for oil fields since investment size is small. Other means of managing sovereign risk. Exxon-Mobil chooses project finance for the pipeline to diversify and mitigate risk. Involves the two nations to prevent post opportunistic behavior with the export system.

Case : Calpine Corporation

Background: $1.7bn company with 79% leverage seeking over $6bn in
financing to construct 25 new power plants. Changing Regulatory Environment allows for selling of power at wholesale prices over existing transmission systems with no discrimination in price or access. Firm wants to change from IPP to Merchant power provider.

Key Issues:
Seizing the initiative and exploiting first movers advantage. Possible alternative sources for finance. Limited corporate debt capacity.

Case : Calpine Corporation

Options for Project Structure:
Corporate Finance:
Public Offering of senior notes.

Project Finance :
Bank loans 100% construction costs to Calpine subsidiaries for each plant. At completion 50% to be paid and rest is 3-year term loan.

Revolving credit facility:

Creation of Calpine Construction Finance Co. (CCFC) which receives revolving credit. Debt Non-recourse to Calpine Corp. High degree of leverage (70%). 4 year loan allowing construction of multiple plants.

Case : Calpine Corporation

Comparison of Financing Routes:
Corporate Finance:
Higher leverage: violates debt covenant for key ratios. Issuance of equity to sustain leverage would dilute equity. Debt affected by the volatility in the high yield debt market.

Project Finance:
Very high transaction costs given size of each plant. Time of execution: potential loss of First Mover advantage.

Hybrid Finance:
Best of Corporate and Project Finance. Low transaction costs and shorter execution time. New entity can sustain high debt levels: ability to finance. Non-recourse debt reduces distress cost for Calpine Corp.

Case : Iridium LLC

Background: A $5.5bn satellite communications project backed by
Motorola which went bankrupt in 1999 after just one year of operations. Had partners in over 100 countries.

Issues:
Scope of the project: 66 satellites, 12 ground stations around the world and presence in 240 countries. High technological risk: untested and complex technology. Construction risk: uncertainty in launch of satellites. Sovereign risk: presence in 240 countries. Revolving investment: replace satellites every 5 years.

Case: Iridium LLC

Structural highlights:
Stand alone entity: Size, scope and risk of the project in comparison to Motorola. Allows for equity partnerships and risk sharing. Target D/V ratio of 60%:
Cannot be explained by trade off theory since tax rate is 15% only. Pecking order theory and Signaling theory also do not explain the high D/V ratio. Agency theory best explains the D/V: Management holds only 1% of equity and the project has projected EBITDA of $5bn resulting in high agency cost of equity. Also, since Iridium has no other investment options, risk shifting and debt overhang do not increase agency costs of debt.

Partners participating through equity and quasi equity to deter opportunistic behavior and align partner incentives.

Case: Iridium LLC

Financing choices:
Presence of senior bank loans:
lower issue costs. Act as trip wire. Easier to restructure. Avoids negative arbitrage (disbursed when required). Duration aligned with life of satellites. Provide external review of the project.

Sequencing of financing:
Started with equity during the riskiest stage (research) since debt would be mispriced due to asymmetric information and risk. In development, brought in more equity, convertible debt and high yield debt. This portfolio matches the risk profile then. For commercial launch, got bank loans: agency motivations emerge.

Case: Iridium LLC

Contention: The Structuring and financing of Iridium was faulty and partially responsible for its demise. Reality: Since Iridium was incorporated as an independent entity and not corporate financed, its prime sponsor Motorola is still solvent inspite of Iridiums bankruptcy. Moreover, the Bank loan default which seemingly triggered the bankruptcy also avoided fresh capital from being ploughed into what was essentially a technologically doomed project.

Case : Bulong Nickel Mine

Background: In July 1998 Preston Resources bought the Bulong Nickel
Mine in the pre-completion phase and financed it with a bridge loan. The bridge loan was financed with a 10 year project bond in December 1998. Within one year, Bulong defaulted on the notes after operational problems.

Issues:
Concentrated and weak equity ownership: Preston Resources. Cash flows very close to debt service. Processing technology is unproven. The output faces severe market risk and currency risk. The company has exposure to currency risk through forward contracts.

Case: Bulong Nickel Mine

Structural / financing highlights:
Project finance: the right choice given the nature of the project and its size relative to the sponsor. 72% D/V ratio: very high given the projected cash flows of the project. Severely limits flexibility. Optionality: financial structure resembles an out of the money call option from the sponsors perspective. Importance of completion guarantees: EPC agency guarantees commissioning of plant and not ramp up. This misinterpretation of completion guarantee results in project exposure to technology risk. Project Bonds instead of bank loans: Motivation is flexibility in future investment (Preston has a similar project on the cards which it wants to facilitate with Bulong cash flows). However bonds limit flexibility during restructuring and delays it by 2 years.

Contents
The MM Proposition What is a Project? What is Project Finance? Project Structure Financing choices Real World Cases Project Finance: Valuation Issues

Project Finance: Valuation Issues

Valuation Issues in Projects Traditional and Non Traditional Approach Capital Cash Flow Method Appropriate Discount Rate Valuing Risky debt Real Options

Valuation Issues in Projects

Projects are exposed to non-traditional risks (discussed earlier). Have high and rapidly changing leverage. Typically have imbedded optionality. Tax rates are continuously changing. Projects have early, certain and large negative cash flows followed by uncertain positive cash flows.

Failure of Traditional Valuation

Usage of Corporate WACC is inappropriate:
Different risk profile of the project from the sponsor. Project has rapidly changing leverage. Considers promised return on risky debt and not expected return.

Traditional DCF method is inaccurate:

Single discount rate does not account for changing leverage. Ignores imbedded optionality. Idiosyncratic risks are usually incorporated in the discount rate as a fudge factor.

Non-Traditional Approaches
Using Capital Cash Flow method which acknowledges changing leverage and uses unlevered cost of capital. Usage of non CAPM based discount rates especially for emerging markets investments. Valuation of risky debt as a portfolio of risk free debt and put option. Incorporation of imbedded Optionality: Valuation of Real Options. Usage of Monte Carlo Simulations to incorporate idiosyncratic risks in cash flows and to value Real Options.

Capital Cash Flow Method

Computing capital cash flow:
Take Net Income (builds in tax shields directly) Add depreciation and special charges, Add interest Subtract change in NWC and Subtract incremental investment.

Discount capital cash flow with unlevered cost of equity to arrive at firm value. Equity value can be derived by subtracting risky debt value. Advantages:
Incorporates effect of changing leverage. Avoids calculation of debt discount rate. Assumes tax shields are at similar risk as whole firm.

Discount Rate for Project Finance

Corporate WACC is an inappropriate discount rate (discussed above). Incorporate idiosyncratic risks in cash flows and account for systematic risks in discount rate. Avoid double accounting. Ensure that discount rate is consistent with the cash flow: unlevered rate for capital cash flows.

Discount Rate in Emerging Markets

This is a major area of concern:
Many mega projects are in emerging markets. Many of these markets do not have mature equity markets. It is very difficult to estimate Beta with the World portfolio. The Beta with the World portfolio is not indicative of the sovereign risk of the country (asymmetric downside risks). E.g. Pakistan has a beta of 0. Most assumptions of CAPM fail in this environment.

Many Alternatives!
Approaches to calculating the Cost of Capital in Emerging Markets:
World CAPM or Multifactor Model (Sharpe-Ross) Segmented/Integrated (Bekaert-Harvey) Bayesian (Ibbotson Associates) CAPM with Skewness (Harvey-Siddique) Goldman-integrated sovereign yield spread model Goldman-segmented Goldman-EHV hybrid CSFB volatility ratio model CSFB-EHV hybrid Damodaran

Many Alternatives!
Many of these methods suffer problems:
Method does not incorporate all risks in the project. Assume that the only risk is variance. Fail in capturing asymmetric downside risks. Assume markets are integrated and efficient. Arbitrary adjustments which either over or underestimate risk. Confusing bond and equity risk premia.

The Country Risk Rating Model

Erb, Harvey and Viskanta (1995) Credit rating a good ex ante measure of risk Reasonable fit to data Fits developed and emerging markets

The Country Risk Rating Model

Sources
Institutional Investors semi-annual Country Credit Rating

The Country Risk Rating Model

Returns and Institutional Investor Country Credit Ratings from 1990
0.5 Average returns 0.4 0.3 0.2 0.1 0 -0.1 0 20 40 Rating 60 80 100 R = 0.2976
2

The Country Risk Rating Model

Steps:
Cost of Capital = risk free + intercept - slopexLog(IICCR)
Where Log(IICCR) is the natural logarithm of the Institutional Investor Country Credit Rating

Gives the cost of capital of an average project in the country. If cash flows are in local currency, then add forward premium less sovereign risk of the currency to the cost of capital. Adjust for global industry beta of the project. Adjust for deviations in the project from the average level of a given risk in the country

The Country Risk Rating Model

Risks incorporated in cash flows:
Pre-completion: technology, resource, completion. Post-completion: market, supply/input, throughput.

Risks incorporated in discount rate:

Sovereign risk: macroeconomic, legal, political, force majeure. Financial risk.

Valuing Risky Debt

Differentiate between expected yield and promised yield. Options approach:
Face value of corporate debt: k (strike price) Underlying assets of the firm: S Equity value: C(k) (call value with strike price = k) Riskless debt: PV (k,r) (r: risk free rate of interest) Put option: P(k) (put value with strike price = k) By Put-Call Parity: S = C(k) + PV (k,r) P(k) Value of risky debt, V(D): PV (k,r) P(k)

Valuing Multiple Classes of Risky Debt

Senior debt: face value = D1; strike price, k1 = D1. Junior debt: face value = D2; strike price, k2 = D1+D2. Value of senior debt, V(D1) = V(riskless,D1) P(k1) Value of junior debt, V(D2) = V(riskless,k2) P(k2) V(D1) Value of total debt, V(D) = V(D1) + V(D2)

Effect of Covenants on Debt Value

Management actions that result in risk shifting, increase equity value (call) and decrease debt value (put):
"Bet the firm" on a new technology that may have a small chance of success. Pay out large current dividends to shareholders. The future collateral of the firm will be reduced. Get new debt at the same seniority level and repurchase shares.

Bank covenants to deal with such actions:

New investment decisions need prior lender approval. Cash Waterfall: Pre-determine distribution of cash flows. Limitations on new debt and distribution to debtholders.

Bank covenants limit managerial discretion and preserve value of debt.

Real Options: Generic Types

Real Options in Project Finance

Scale up: Are usually in the form of replication. These also include contractual real options in the form of leases etc. Affects project NPV. Switch up: Affects project NPV. Scope up: Affects value of Sponsors involvement. Study/start: Affects project NPV. Critical for stock type projects where precise estimation of reserves is critical to success.

Real Options in Project Finance

Scale down: Mostly applicable in the pre-completion stage. Scale down is rarely an option post-completion since projects are valuable almost exclusively as going concerns. Affects project NPV. Switch down: Rarely an option for a project. Scope down: Similar to the scale down option. Flexibility option: The option to switch input or output mix is key to projects and can help reduce cash flow volatility. Affects project NPV.

Real Options: Industry Examples

Automobile: Recently GM delayed its investment in a new Cavalier and switched its resources into producing more SUVs. Aircraft Manufacturers: Parallel development of cargo plane designs created the option to choose the more profitable design at a later date. Oil & Gas: Oil leases, exploration, and development are options on future production; Refineries have the option to change their mix of outputs among heating oil, diesel, unleaded gasoline and petrochemicals depending on their individual sale prices. Telecom: Lay down extra fiber as option on future bandwidth needs

Real Options: Industry Examples

Real Estate: Multipurpose buildings (hotels, apartments, etc.) that can be easily reconfigured create the option to benefit from changes in real estate trends. Utilities: Developing generating plants fired by oil & coal creates the option to reduce input costs by switching to lower cost inputs. Airlines: Aircraft manufacturers may grant the airlines contractual options to deliver aircraft. These contracts specify short lead times for delivery (once the option is exercised) and fixed purchase prices.

Real Options: Valuation Approaches

Black Scholes formula:
The PV of cash flows is asset price and the variation in returns is volatility. It is difficult to find real world situations which fulfill assumptions underlying the BSM.

Binomial Option Pricing model:

The most illustrative method. Have to incorporate varying risks of cash flows at each decision node. It is better to risk adjust the cash flows and use a risk free rate.

Monte Carlo Simulation:

The most robust and accurate method. Easy to integrate multiple and interacting real options. Can be used to accurately value an option when multiple options are present by comparing the analysis results with and without the option.

The MM Proposition
M&M premise of Structure irrelevance No transaction Costs No taxes No cost of Financial Distress No agency conflict No asymmetric Information Real World situations Very high transaction costs that can affect the investment decision. Taxes are mostly positive and high and results in valuable tax shields. Capital and governance structure decreases risk thereby decreasing cost of distress. Behavior of various parties can be controlled through structure. Type and sequence of financing can improve information.

The MM Proposition
Since real world situations do not always fulfill the assumptions of the MM Proposition, capital structure does affect firm value in reality.

Acknowledgements
The content of this presentation has been derived primarily from the:

Project Finance course taught by Benjamin Esty at the Harvard Business

School.

Emerging Markets Corporate Finance course taught by Campbell Harvey at

Duke University.

Advanced Corporate Finance course taught by Gordon Phillips at Duke

University. We thank the above for their contribution to this effort. We also acknowledge the usage of content from Project Finance International and Journal of Applied Corporate Finance. We thank them for access to their databases.