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INTRODUCTION
Project finance has come of age in India. The promoter/entrepreneur has
a wide choice of sources of funds out of which he can choose. The choice, of course,
governed by the cost of funds and financial risk. Funds availability should no longer
restrict the choice of a project and the technology. The project should be technologically
sound, second to none in the world and financially viable. Otherwise the competitive
strength would be compromised. Time has come to assess costs and productivity in
international terms. The relevance of the project has to be established in international
context. A good, sound and viable project would have no problem in finding market
acceptance. Project finance is to be financed by borrowing from term lending
institutions.
Project financing is commonly used as a financing method in capitalintensive industries for projects requiring large investments of funds, such as the
construction of power plants, pipelines, transportation systems, mining facilities,
industrial facilities and heavy manufacturing plants. The sponsors of such projects
frequently are not sufficiently creditworthy to obtain traditional financing or are
unwilling to take the risks and assume the debt obligations associated with traditional
financings. Project financing permits the risks associated with such projects to be
allocated among a number of parties at levels acceptable to each party.
HISTORY
The origins of project finance can be traced to the construction of the
Panama Canal, although the modern origins are the power projects of the 1970s and
1980s where newly created Special Purpose Corporations (SPCs) were created for each
project, with multiple owners and complex schemes distributing insurance, loans,
management, and project operations. Such projects were previously accomplished
through utility or government bond issuances, or other traditional corporate finance
structures.
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The new project finance structures emerged primarily in response to the
opportunity presented by long term power purchase contracts available from utilities
and government entities. These long term revenue streams were required by rules
implementing PURPA, the Public Utilities Regulatory Policies Act of 1978.
Originally envisioned as an energy initiative designed to encourage domestic renewable
resources and conservation, the Act and the industry it created lead to further
deregulation of electric generation and, significantly, international privatization
following amendments to the Public Utilities Holding Company Act in 1994.
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- infrastructure improvements (including power stations)
- new industrial plants (factories).
DEFINITION
Project financing involves non-recourse financing of the development and
construction of a particular project in which the lender looks principally to the
revenues expected to be generated by the project for the repayment of its loan
and to the assets of the project as collateral for its loan rather than to the general
credit of the project sponsor.
It is a method of financing very large capital intensive projects, with long
gestation period, where the lenders rely on the assets created for the project as
security and the cash flow generated by the project as source of funds for
repaying their dues.
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Project Financing Flowchart
Preparation of Feasibility Report
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PRINCIPAL ADVANTAGES AND OBJECTIVES
1. Non-recourse
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DISADVANTAGES
Project financings are extremely complex. It may take a much longer
period of time to structure, negotiate and document a project financing than a traditional
financing, and the legal fees and related costs associated with a project financing can be
very high. Because the risks assumed by lenders may be greater in a non-recourse
project financing than in a more traditional financing, the cost of capital may be greater
than with a traditional financing.
4. Operator: The project operator enters into a long-term agreement with the
project company for the day-to-day operation and maintenance of the project.
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6. Product Off taker: The product off taker(s) enters into a long-term
agreement with the project company for the purchase of all of the energy, goods
or other product produced at the project.
the need to allocate tax benefits in a specific manner among the project company
investors.
The three basic forms for ownership of a project are:
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frequently will form a wholly owned, single-purpose subsidiary to act as its
general partner in a partnership.
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PRINCIPAL AGREEMENTS IN A PROJECT FINANCING
A] Construction Contract: Some of the more important terms of the construction
contract are:
4. Completion Date: The construction completion date, together with any time
extensions resulting from an event of force majored, must be consistent with the parties'
obligations under the other project documents. If construction is not finished by the
completion date, the contractor typically is required to pay liquidated damages to cover
debt service for each day until the project is completed. If construction is completed
early, the contractor frequently is entitled to an early completion bonus.
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feedstock or pay the project company the difference in costs incurred in obtaining the
feedstock from another source. The price provisions of feedstock supply agreements
must assure that the cost of the feedstock is fixed within an acceptable range and
consistent with the financial projections of the project.
C] Product Off take Agreements: In a project financing, the product off take
agreements represent the source of revenue for the project. Such agreements must be
structured in a manner to provide the project company with sufficient revenue to pay its
project debt obligations and all other costs of operating, maintaining and owning the
project. Frequently, off take agreements are structured on a "take-or-pay" basis, which
means that the off taker is obligated to pay for product on a regular basis whether or not
the off taker actually takes the product unless the product is unavailable due to a default
by the project company. Like feedstock supply arrangements, off take agreements
frequently are on a fixed or scheduled price basis during the term of the project debt
financing.
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3. Covenants Not to Amend: The borrower will covenant not to amend or waive
any of its rights under the construction, feedstock, off take, operations and maintenance,
or other principal agreements without the consent of the lender.
9. Security: The project loan typically will be secured by multiple forms of collateral,
including:
A] Mortgage on the project facilities and real property.
B] Assignment of operating revenues.
C] Pledge of bank deposits.
D] Assignment of any letters of credit or performance or completion bonds relating to
the project under which borrower is the beneficiary.
E] Liens on the borrower's personal property.
F] Assignment of insurance proceeds.
G] Assignment of all project agreements.
H] Pledge of stock in Project Company or assignment of partnership interests.
I] Assignment of any patents, trademarks or other intellectual property owned by the
borrower.
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F] Site Lease Agreement: The project company typically enters into a long-term
lease for the life of the project relating to the real property on which the project is to be
located. Rental payments may be set in advance at a fixed rate or may be tied to project
performance.
2. Construction Agreement
A construction agreement is the agreement whereby one person (the contractor) agrees
to construct a building or a facility for another person (the employer) for an agreed
remuneration by an agreed time.
In a complex construction project comprised of various interlocking parts (involving
both civil and mechanical and electrical works), the basic decision to be taken is
whether to have a contractor responsible for all of the works (a "turnkey" contract,
contrat de construction cl en main) or to have the individual contractors enter into
separate contracts with the employer but to have them subject to control by one overall
project manager.
Often a turnkey contract is preferred in order to insure that the turnkey contractor
assumes overall risk for completion as well as the risk of performance of the subcontractors.
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The main clauses of this agreement involve :
- technical specifications, - authorizations to be obtained for the works, - completion
agenda, - testing procedures and performance parameters,
- determination of phase / final completion, - fixed price and provision relating to
"overruns" and payments, - liquidated damages payable for delay in achieving
completion, - transfer of property and risk,
- construction bond/completion guarantees (garantie d'achvement), - insurance
arrangements, - cooperation and coordination during the works, - final provisions
(governing law, dispute resolution etc.).
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5. Supply Agreements
In most instances the project company will need to enter into a number of supply
agreements in order to purchase the main supplies for the operation of the project
facility. These may include feed stock (raw materials for the manufacturing process),
fuel (for electricity generation or for the supply of power to the plant) or renewable
equipment.
The main clauses of this agreement involve:
- level of supply, - price (fixed or indexed), - supply guarantee, - quality of supply, liquidated damages,
- final provisions.
6. Off-Take Agreements
A project need not necessarily have an off-take agreement in the sense of a long term
product purchase agreement since:
- its products may only be capable of being sold on world spot markets (e.g. crude oil),
- its revenues may simply be payments from the general public (of tolls or fares).
An off-take agreement is a long-term sale agreement of the project products with one or
more off-takers with the following characteristics :
- long-term sales, - fixed or agreed price, - purchase guarantee ("take-or-pay").
Other
The project company will in all instances enter into assurance arrangements. The project
company may also enter into a technical assistance agreement.
FINANCE DOCUMENTS
1. Loan Agreement
This agreement is entered into between the project company and a bank or a syndicate
of banks represented by an agent acting in their name and on their behalf if the loan is
syndicated.
This agreement will provide for the partial financing of the project (since the project
will also be financed by equity, subordinated loans, host government subsidiaries, etc.)
The loan agreement will contain the following provisions :
> Basic Provisions : - general conditions precedent,
- conditions precedent to each drawdown, - drawdown mechanics, - interest clause
(Euribor, Libor, etc.. plus margin), - repayment clause, - margin protection clauses
(gross-up clause, increased costs and market disruption), - illegality clause, -
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representations and warranties, - undertakings, - events of default.
> Specific Provisions : - non-recourse or limited recourse clauses, - cover Ratios and
Net Present Value, - control accounts (disbursement account, proceeds account,
compensation account (for insurance payments), debt service reserve account and a
maintenance reserve account), - hedging (protection of a borrower from adverse
movements in currency exchange rates, interest rates and commodity prices)
Security Package
Lenders take security over an asset or a right in order to sell it if their loan is in default
and to apply the proceeds against amounts outstanding under the loan.
In project finance the lenders' main legal concern is also to ensure :
- that they can take effective security over the main project contracts,
- that the key contracts remain in place in one from or another if and when they enforce
their security.
In order to achieve the first concern, each contract must be charged or assigned to the
lenders by way of security and any consents required from the other contracting parties
for this to occur must be obtained.
In order to achieve the second concern, it will be necessary to examine the termination
clauses in each contract. Often, there will be provisions entitling the other contracting
parties to terminate the contract if the project company is insolvent or if any security it
gives is enforced. For this reason, lenders will usually seek to have the provisions
amended or to have the other parties enter into direct agreements with them.
2. Direct Agreement
Direct agreements are agreements entered into between the project company, the banks
financing a project and the parties to the projects' key commercial contracts.
The key contracts for these purposes would typically include the concession agreement
(if any) the construction agreement, any long-term supply agreement and any long-term
sales agreement.
Direct agreements are also sometimes sought from the authorities issuing consents
necessary for the project.
The objective of a direct agreement is basically to enable the banks to "step into the
shoes" of the project company if it defaults in its loans obligations.
Banks would usually expect a direct agreement relating to a commercial contract to
contain the following :
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- consent from the third party to the project company charging or assigning by way of
security the project company's rights under the relevant contract (to such extent such
consent was required),
- an undertaking from the third party that it would not exercise any right it had to
terminate the contract without first giving the banks a specific number of days' prior
written notice,
- an agreement from the third party that, if it gave the banks notice of the type referred
to above and the lenders in turn gave it a counter notice, then the third party would
either allow the banks (or an agent appointed by them) to assume the project company's
rights and obligations under the contract for a specified period of time or allow the
transfer of the contract to a separate company (a "work-out" vehicle) established by the
banks for this purpose.
3. Intercreditor Agreement
The intercreditor issues that arise in project financing are related to situations where
there is more than one provider of debt finance. If one layer of finance is to be
subordinated to another, an intercreditor agreement will usually set out the terms of the
subordination.
If no layer of finance is to be subordinated to another, an intercreditor agreement will
usually address issues such as whether all of the categories of lenders have to agree
before any of them can accelerate their loans or take enforcement action and whether or
not any category of lenders is to have the right to veto any proposed exercise of a
discretion under any other lenders' credit documentation.
Intercreditor agreements will typically contain the following provisions : - voting
arrangements and procedural provisions relevant to decision making,
- appointment of agents and similar entities to perform specific functions on behalf of
groups of lenders,
- disclaimer provisions for the benefit of agents,
- application of cash as amongst different groups of lenders (not all of them may have
the benefit of the same security), - order of application of cash as to specific project and
lender requirements ("waterfall" "cascade")
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INSURANCE
The general categories of insurance available in connection with project
financings are:
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Feasibility Study
After ensuring that a project idea is suitable for implementation, a detailed
feasibility study giving additional information on financing, breakdown of cost of
capital and cash flow is prepared. Feasibility study is the final document in the
formulation of a project proposal. Feasibility studies can be prepared either by the
entrepreneur or consultants or experts. The cost of the feasibility study can be debited to
the project cost and can be counted as apart of promoters contribution.
The feasibility study should contain all technical and economic data that
are essential for the evaluation of the project. Before dealing with any specific aspect,
feasibility study should examine public policy with respect to the industry. After that, it
should specify output and alternative techniques of production in terms of process
choice and ecology friendliness, choice of raw material and choice of plant size. The
feasibility study, after listing and describing alternative locations, should specify a site
after necessary investigation. The study should include a lay-out plan along with a list of
buildings, structures and yard facilities by type, size and cost. Major and auxiliary
equipment by type, size and cost along with specification of sources of supply for
equipment and process know-how has to be listed. The study has to identify supply
sources and present estimates, costs for transportation, services, water supply and
power. The quality and dependence of raw materials and their source of supply have to
be investigated and presented in the feasibility study. Before presentation of the
financial data, market analysis has to be covered to help in establishing and determining
economic levels of output and plant size.
Financial data should cover preliminary estimates of sales revenue, capital
costs operating costs for different alternatives along with their profitability. Feasibility
study should present estimates of working capital requirement to operate the unit at a
viable level. An essential part of the feasibility study is the schedule of implementation
and estimates of expenditure during construction.
The feasibility study is followed by project report firming up all the
technical aspects such as location, factory lay-out specifications and process techniques
design. In a way, project report is a detailed plan of follow-up of project through various
stages of implementation.
A feasibility report should contain inter alias an examination of public
policy with respect to the industry, listing of equipment by type, size and cost and
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specification of sources of supply for equipment, broad specification of outputs and
alternative techniques of production in terms of choice of process, plant size and raw
material, listing and description of alternative location, capital costs, estimates of sales
revenue and operating costs for different alternatives, estimation of demand for product,
sources of raw material supply, listing of buildings and structures by type, size and cost,
specification of supply sources and costs for transportation services, water supply and
power, preparation of layout, labor requirement and cost, working capital requirement,
plan for execution of project and expenditure during construction , analysis of
profitability, pollution control method and experience of promoters in execution of
projects in the past.
B] Contents: The feasibility study should analyze every technical, financial and other
aspect of the project, including the time-frame for completion of the various phases of
the project development, and should clearly set forth all of the financial and other
assumptions upon which the conclusions of the study are based, Among the more
important items contained in a feasibility study are:
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Description of project.
Description of sponsor(s).
Sponsors' Agreements.
Project site.
Governmental arrangements.
Source of funds.
Feedstock Agreements.
Construction Contract.
Management of project.
Capital costs.
Working capital.
Equity sourcing.
Debt sourcing.
Financial projections.
Market study.
Assumptions.
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THE STAGES OF PROJECT SELECTION
The identification of project ideas is followed by a preliminary
selection stage on the basis of their technical, economic and financial soundness.
The objective at this stage is to decide whether a project idea should be studied in
detail and to determine the scope of further studies. The findings at this stage are
embodied in a prefeasibility study or opportunity study. For the purpose of screening
and priority fixation, project ideas are developed into prefeasibility studies.
Prefeasibility studies give output of plant of economic size, raw material
requirement, sales realization, and total cost of production, capital input/output ratio,
labor requirement, power and other infrastructure facilities. The project selection
exercise should also ensure that it conforms to overall economic policy of the
government.
PROJECT IDENTIFICATION
A project is a proposal for capital investment to develop facilities to
provide goods and services. The investment proposal may be for setting up a new
unit, expansion or improvement of existing facilities. The project, however, has to
be amenable for analysis and evaluation as an independent unit.
A project is a specific, finite task to be accomplished in order to
generate cash flows. The projects undertaken after liberalization are large and
getting larger. They have increased in size and complexity. Projects for tomorrow
are not geared to the mass production of simpler goods but customized ones
produced by flexible manufacturing systems.
Project idea can be conceived either from input or output side. The
former are material based while the latter, demand oriented. Input based projects are
identified on the basis of information about agricultural raw materials, forest
products, and animal husbandry, fishing products, mineral resources, human skills
and new technical process evolved in the country or elsewhere. Output based
projects are identified on the basis of needs of population as revealed by family
budget studies or industrial units as found by market studies and statistics relating to
imports and exports. Desk research surveying existing information is economical
and wherever necessary market surveys assessing demand for the output of project
could help not only in identification but in assessing viability of the project.
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Project identification is however a continual process. With the opening
up of the economy, demand for sophisticated inputs is continuously rising. The quest
for new combinations of factors for optimizing output and improving productivity to
strengthen the competitive position of Indian industry in the international market
place is an ongoing process. Further, the growing demand for complex,
sophisticated, customized goods and services in international markets has added a
new dimension to project concept.
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Tasks of the Project Manager
The project managers tasks can be divided into four categories:
(1) Technical
(2) Personnel
(3) Administrative
(4) External Relations
The tasks relating to the technical aspects are planning, scheduling of
work, setting of priorities, task identification, looking into the logistics, and
specification of equipment use. The personnel aspect involves building up of
organization and recruitment of staff as per the requirements, leading and motivating
the staff to perform, building communication channels, resolution of conflicts,
conducting negotiation with various parties, and performance evaluation.
Administrative tasks include estimating and controlling of costs, budgeting, cash
flow monitoring, devising and using the management information system, evolving
systems and procedures for various operations including the procurement of raw
materials, and finally the terminal project evaluation. The project manager has also
to manage the external relations of the unit. These tasks include relations of the unit.
These tasks include relations with financial institutions, contracting and using the
consultants, dealing with suppliers and sub-contractors, and co-ordination with other
agencies including government agencies.
All the above mentioned tasks of the project manager need to be
performed at both pre-operation and operation phases of a unit. Then nature and
complexity of these tasks are, however, different in the operation phase as compare
to the pre-operation phase.
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Problems in Pre-Operation Phase
The most important problem faced in the implementation phase
of the project is delay in the execution of projects. It has been observed that as many
as 95 percent of the projects taken up by the public sector could not be completed in
time and sometimes delays were even more than 50 percent of the time in which a
project was expected to start functioning. The problem of delay in the project
management terminology is also referred as the slippage of projects. The slippage of
projects results in escalation of costs and also the losses of revenue, and thereby
making the initial assumptions made in the feasibility report completely out of line.
The delays are generally caused by the two main factors: Delays caused by internal
factors and delays caused by external factors.
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handling such a project. In most of the contracts, terms and conditions are not laid
down in clear language which provides enough room for disputes at later stages
causing stoppage of work at a crucial point upsetting the entire process. Contract
documents do not include the realistic terms and conditions as per requirements of
the project, schedule of construction of different phases, and other sub-contracted
jobs. Of course, delays also occur in preparation of the contract document, selection
of contractors through tenders, and signing of contracts.
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Tasks of Project Manager in Pre- Operation and
Operation Phases (Fig.1)
The Project Manager
1. Technical Aspects
2. Personnel
3. Administration
4. External Relations
Technical Aspects
1. Planning, Scheduling
2. Setting of Priorities
3. Task Identification
4. Logistics
5. Equipment Use and Schedules
Personnel
Administration
External Relations
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Operating Procedures for Getting Working Capital
The working capital is the amount of funds which a unit needs to finance
its day-to-day operations and in this sense it can be regarded as that part of the total capital
which is employed in the short-term operations. The constituents of the working capital are
stocks of raw materials and suppliers, work-in-progress, finished goods, book debts and the
minimal cash, and bank balances. The working capital needs of the unit are essentially to
be met by borrowings from the commercial banks. Till recently there were no standards or
guidelines for setting out the precise amount of gross or net working capital needed by
various enterprises. Recently however, a particular study group which looked at the
question suggested the guidelines with a view to: (1) make customer plan his credit needs
in advance and observe discipline in its use; (2) indicate to the banker the likely demand for
credit and thus enable him to plan his own deposit-credit function; (3) assure finance to
industry for its genuine production needs; (4) having provided finance, enable the banker to
receive from the customer adequate flow of information on the use of credit, but withinbuilt flexibility to suit changes in circumstances. As per the guidelines of the committee,
the commercial banks have to understand and interpret the extent of working capital gap in
borrowers business at any given time and decide the appropriate method of arriving at the
maximum permissible level of bank credit to the borrower. The study group presented three
alternatives, which can also be considered at three sequential stages, for deciding the
maximum permissible bank finance:
Method I: Determine the working capital gap, i.e. a reasonable level of total current
assets minus non-bank current liabilities and reckon 75 percent of the working capital gap
as the permissible level of bank finance. The balance has to be found by the borrower from
his own funds and/or from long-term borrowings.
Method II: The borrower will have to get his own resources and/or long-term funds to
finance 25 percent of the total current assets. Whatever is then required to meet the
working capital gap will be provided by the banker.
Method III: Determine the core current assets. These have to be financed out of own
fund and/or long-term borrowings. The reasonable level of total current assets less core
current assets will represent real current assets. Twenty-five percent of real current assets
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will also have to be supported by the borrowers own funds and/or long-term borrowings. If
the non-bank current liabilities are inadequate to cover the balance 75 percent of the real
current assets, the required amount will be obtained by way of bank borrowings.
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accounting, costing and record keeping. Although the debt-equity ratio and the
promoters contribution requirements have been considerably liberalized, in practice
entrepreneurs need higher equity base to at last tide over unforeseen cost escalations. In
the absence of such a base, even managerial cost escalations create problems for
functioning of the unit. It has also been observed, particularly in the case of industrial
units, that the working capital requirements are not anticipated and forecasted well.
Therefore, commercial banks grant the working capital limits which are not sufficient
to take care of various production and marketing requirements. When the unit begins to
face the constraint of working capital, production suffers. Bankers became reluctant to
grant additional limits. The unit then gets into the vicious circle.
Lack of project accounting, costing, and record keeping makes
the cost control and pricing decisions difficult, leading to financial problems. This is
observed more so in the case of several industrial units where there are no qualified
accountants. Once the problems crop up, banks begin to ask for various kinds of data
which is difficult for these units because the data simply do not exist in that form.
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Problems of Industrial Relations and Operating Style
Industrial parce and workers co-operation are key factors in
realizing production build-up as anticipated. Units get into difficulty in early stages
because of labour problems. Some of the labour problems can be traced to the operating
styles of the entrepreneur and lack of managerial effectiveness. Sometimes promoters
themselves do not operate as a cohesive group. There are cases where doubleful
integrity and entrepreneurial commitment to project on the part of promoters cause
problems for operating the unit profitably
1. Marketing Problems
Many small scale and industrial units face problems in marketing
their products. Some of these problems can be traced back to inadequate market
analysis at the project formulation stage. Other marketing problems arise because of
inappropriate marketing strategy and or low-key market development effort. Some of
the industrial products require longer gestation periods than initially expected in
developing the tastes and clientele.
2. Environmental Problems
These are problems that arise from changes in external environment
faced by the unit. These changes arise because of changes in government policies
and/or critical shortages of raw material and utilities. For example, time to time serious
shortages of coal and power cuts cause problems for production. Ban on movement of
final product also creates problems in realizing the remunerative prices and, therefore,
problems of capacity get aggravated.
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Types of Ratios
1. Pay back Period (P): The pay back period is defined as the time period within
which the initial investment on the project is recovered by the unit in the form of revenues.
To put it differently this is the length of time between the initial investment on the project
and the time when this initial investment is completely recovered from the net yearly
revenues. In symbolic terms if the net yearly cash flows are same every year, we can
express the pay back period as follows:
P= I
C
Where P is pay back period
I is the initial investment and
C is the yearly net cash inflow.
2. Net Present Value (NPV): The net present value of investment is calculated by
taking a discounted sum of the stream of net income during the expected life of the project
It is necessary to discount the future stream of net income because costs and returns in
different time periods are not strictly comparable. In symbolic terms we can express the
NPV of a project generating net cash flows of R1, R2, R3, ., Rn for n years as follows:
NPV = R1 + R2
(1+ r)
(1+ r)
+ + Rn
-I
(1+ r)
where 100 r percent is the discount rate. The investment is considered sound if the NPV is
positive. A negative NPV indicates that the project is not worth considering at a given
discount rate.
3. Internal Rate of Return (IRR): The internal rate of return is that rate of return
which makes the net present value equal to zero. Thus, it is the discount rate which makes
the initial investment in the project equal to the discounted net returns from the investment
during the entire life of the project, In symbolic terms we can express it as:
n
Rt
I=0
(1 + r) t
t=0
where Rt are the net returns in each of the n years and (1 + r)t is the discount factor. In this
case R is to be estimated such that the discounted net returns from the project equal zero.
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The estimated value of R is then compared with the cost of capital. If the internal rate of
return (IRR) is higher or equal to the minimum desired yield or rate of return, then we
accept the project proposal. Otherwise, the project is rejected and as a corollary to this
between the two projects if one yields higher IRR than the other, the first one is preferred to
the second.
To enable the entrepreneurs to form a judgment about the efficiency of the
enterprise, creditworthiness, and his return on key aggregates, some financial ratios can be
computed from the projected financial statements of the unit.
4. Efficiency Ratios: As the name indicates these ratios provide information on the
efficiency of the proposed industrial unit. Some of the important ratios in this regard
include inventory include turn-over and operating ratios.
6. The Operating Ratio: This ratio is computed by dividing the operating expenses
with the revenue. This ration indicates the ability of the unit to control operating costs
including overhead expenses. This ratio is generally used in comparing the performance
over the time of the same unit or comparing the performance of he proposed unit with that
of other units. If it is observed from the projected statements that the ration increased over
time, it implies either the cost of raw materials is increasing or the labour cost is increasing
or there are wastages in the production process and/or there is substantial competition
necessitating a reduction in prices. When the operating ratio becomes very high the unit
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may have difficulty in making an adequate return. On the other hand, if this ratio is very
low, one has to examine whether some of the cost items have been omitted.
(A) Return on sales: This ration indicates the operating margin of the unit on its sales.
If the return on sales or the operating margin is low it implies that the unit will have to have
a large volume of sales in order to earn an adequate return on investment. This ratio is
usually used for comparison purposes with the units in the same industry or the same unit
over time. Since the acceptable level of the ratio varies from industry to industry it is
meaningless to compare this ratio across industries.
(B) Return on Equity: This ratio is computed by dividing the net income after tax by
equity. This ratio helps the entrepreneurs to compare various investment opportunities and
select the project proposal which yields a satisfactory return on investment.
(C) Return on assets: This ratio indicates the earning power of the assets of the
proposed unit and it is computed by dividing the operating income by the value of assets. If
the proposal is to be acceptable for entrepreneurs, the return on assets should exceed the
cost of capital; otherwise the project is not viable from the point of view of the
entrepreneurs in the sense this ratio is close to the calculations or indicators of the financial
viability in the previous section.
8. The Creditworthiness ratio: These ratios indicate the degree of financial risk
inherent in the enterprises before going for them. These ratios also indicate the type of
financing and term the proposed unit would require so that it may be able to survive even
the adverse circumstances. Some of the important ratios in this category are the current
ratio, the debt-equity ratio, and the debt-service coverage ratio.
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9. The Current Ratio: This ratio is computed by dividing the current assets by the
current liabilities. This is an important ratio for the lending agencies to assess the enterprise
in terms of the margin that the proposed unit has for its current assets to shrink in value
before the unit gets into difficulty in meeting its current obligations. The appropriate level
of this ratio depends on the type of industry and trade practices in in the industry where the
proposed unit would belong. For example, if the unit has a large inventory turnover and if it
can collect its accounts receivables promptly, then the current ratio can be lowered. If the
current ratio is very low then, the unit has to exist on a day-to-day basis which may led to
uneconomic practices because it is possible that its output may have to be sold at lower
prices for cash, or it may be able to carry sufficient inventory to meet the production
schedules, or it may have to buy inventories in small lots and, therefore, pay higher prices
for the inventories, etc. Once again, the appropriate level of this ratio for the proposed unit
will have to be judged in the light of other ratios as indicated.
10. Debt-equity Ratio: This ratio is computed by dividing the long-term liabilities by
the sum of long-term liabilities plus equity to obtain the proportion that long-term liabilities
are to total debt and equity, and then by dividing equity by the sum of long-term liabilities
plus equity to obtain the proportion that equity is to the total debt and equity.
11. The Debt Service Coverage Ratio: This ratio can be computed on a before-tax
basis or after-tax basis. If the debt service coverage ratio is computed on a before-tax basis,
it implies that the funds from operations have been divided by interest plus repayment of
long-term loans. If the calculations are done on after-tax basis, it implies that the taxation
expenses have also been taken out and, therefore, it is even sounder. This ratio is computed
as the net income plus depreciation less interest paid divided by interest paid plus the
payment of long-term loans.
It is again very difficult to ascribe any rule of thumb for the debt-service
coverage ratio. This ratio has been interpreted along with the analysis of sources and uses
of funds for the unit and the pool of funds remaining after all requirements for maintenance
and improvements of current operations and orderly expansion. If the ratio decreases over
time, it may be due to the over-ambitious expansion programmed or change in credit terms
which have lengthened the repayment period, etc.
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APPRAISALS IN PROJECT FINANCE
1. TECHNICAL APPRAISAL
A] Appraisal of project
At the outset it may be clarified that the terms evaluation, appraisal and
assessment are used interchangeably. They are used in analyzing the soundness of
an investment project, i.e., in an ex ante analysis of the effects of implementing a
project. The analysis is based on projections in terms of cash flows. The analysis is
carried out by the entrepreneur or promoters of the project, the merchant banker
who is going to be involved in the management and underwriting of public issue
and financial institutions who may lend money.
Evaluation of industrial projects is undertaken to compare and evaluate
alternative opportunities in terms of projects exist for commitment of resources.
Project selection can only be rational if it is superior to others in terms of
commercial profitability i.e. net financial benefits accruing to owners of the project
or on national profitability i.e. net overall importance of the project to the nation as
a whole. The purpose of the project appraisal is to ensure that the project is
technically sound, provides reasonable financial return and conforms to the overall
economic policy of the country.
B] Objectives
Technical appraisal is primarily concerned with the project concept
covering technology, design, scope and content of the plant as well as inputs and
infrastructure facilities envisaged for the project. Basically, the project should be
able to deliver marketable product from the resources deployed, at the cost which
would leave a margin adequate to service the investment and plough-back a
reasonable amount to enable the enterprise to consolidate its position. Technical
appraisal has a bearing on the financial viability of the project as reflected by its
ability to earn satisfactory return on the investment made and to service equity and
debt.
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C] Project Concept
Project concept comprises various important aspects such as plant
capacity, degree of integration, facilities for by-product recovery and flexibility of
the plant. Accurate assessment of plant capacity on a sustained basis is of crucial
importance.
F] Evaluation of Technology
Outstanding features of technology process, engineering design and plant
and machinery are established facts and can be checked from published information
on the process or from prospective collaborators/consultants and on the basis of
similar plants in operation elsewhere. However, considerable skill is required in
evaluating the claims of emergent technology, products and equipment design.
The design and layout of the plant in technical appraisal should ensure
ease of operation and convenience of maintenance and uncomplicated expansion of
the stream capacity, should the need arise.
Above all, in technical appraisal one should be alert and apply trained and
informed skills. For example, the availability of soft water is essential for a textile
processing plant. It is on record that a public sector textile processing plant was set
up without checking the quality of water. The result was a large additional
investment to cure water.
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G] Inputs
In technical appraisal, inputs are scrutinized for availability and quality
dependability. If there are seasonable variations, especially, in the case of
agricultural inputs, variations in price have to be checked. Similarly power quality
has to be checked in terms of variation in supply voltage and in-line current
frequency and duration of black-outs.
H] Location
While it is easy to enumerate desirable factors to be taken into account
while determining location, in practice various constraints dictate location away
from the ideal one. The ideal factors are of course, proximity to the market and
inputs, preferably where well developed infrastructure exists. In some industries
effluent disposal facility is necessary. Pollution control restricts the use of steam
boilers while power scarcity restricts the installation of induction furnaces which
are environment friendly. Antipollution regulations may also force the choice of
large size plants to curtail noise pollution or to install anti-vibration equipment with
adverse impact on costs.
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main physical elements of the projects, from project concept, obtaining Government
approvals, tying-up financial arrangements, engineering design, land acquisition,
building construction, procurement of equipment, its erection and testing to final
commissioning, there must be realistic time schedules and a coherent arrangement,
which leads to the completion of the project on most economical basis.
K] Cost of Production
Estimates of production costs and projection of profitability is the
concluding part of the technical appraisal. Cost of production is worked out taking
into account the build up of capacity utilization, consumption norms for various
inputs and yields and recovery of by-products. In estimating production, a general
build-up starting with 40 percent and reaching a normal level of 80 percent in three
to four years time is provided. In practice capacity utilization may fall short of
estimated levels on account of defective plant and machinery, inadequate operating
skills, inadequacy of raw materials, shortage of power and lack of demand. The cost
of production and profitability estimates take into account the level of production in
different years and product mix, norms of raw material consumption, power and
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fuel requirement, their costs, salaries and wages, repairs and maintenance,
administrative overheads, selling expenses and interest on borrowings. Adequate
provision is made for higher expenses in the initial years for technical troubles,
higher wastages and lower yields, lower operating efficiency and higher selling
costs. Here, too, comparison with similar projects is useful. The profitability
estimates should be on a realistic selling price. In a competitive market, penetration
price for a new producer will have to be lower than the current price of an
established manufacturer
2. MARKET APPRAISAL
a. Introduction
Analysis of demand for the product proposed to be manufactured requires
collection of data and preparation of estimates. Market appraisal requires a description of
the product, its major uses, scope of the market, possible competition from substitutes,
special features of the product proposed to be manufactured in regard to quality and price
which would result in consumer preference for the product in relation to competitive
products. Estimates have to be made about existing and future demand and supply of the
products proposed to be manufactured. An assessment of likely competition in future and
special features of the project which may enable it to meet competition has to be made.
Export possibilities have to be identified and comparative data on manufacturing costs have
to be compiled. It is necessary to identify principal customers and state particulars of any
firm arrangements entered into with them. Selling arrangements contemplated in terms of
direct sales or through distributors or dealers have to be classified.
After collection of data, the existing position has to be assessed to ascertain
whether unsatisfied demand exists. Since cash flow projections are to be made possible
future changes in the volume and the pattern of supply and demand have to be estimated.
This would help in assessing the long term prospects of the unit.
Estimation of demand requires the determination of the total demand fr the
product and the share that can be captured by the unit through appropriate marketing
strategies. The commonly used methods of demand forecasting are trend, regression and
end-use methods.
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b. Trend Method
The trend method assumes that the behavior of the variable would continue in
the same direction and magnitude as in the past. In this method, it is useful first to draw a
graph to ascertain whether a linear or an exponential trend is appropriate for projection.
The assumption under linear trend is that the variable would increase by a constant amount,
whereas in exponential it will change by a constant percentage amount. Graphing the data
will help to decide which period to choose and what type of form be used for forecasting.
Only after analysis of past data the trend line should be fitted.
c. Regression Approach
In regression approach the factors influencing the variables that are to be
forecast have to be identified. In this method we have the dependent variable and the
explanatory or independent variable. The dependent variable is the one subject to
forecasting. The explanatory variables are those which cause changes in the dependent
variable. If the rate of inflation is to be forecast, the independent variables may be money
supply, per capita availability of food grains and rate of monetization of the economy.
Specification or identification of factors is crucial in forecasting by regression approach. In
multiple regressions we have more than one explanatory variable.
The regression coefficients should have the right sign and be statistically
significant. The actual value of dependent variable and the estimated value should be close
to each other for the sample period.
d. End-Use Method
In this method the users of the product, proposed to be manufactured, are
identified. An intensive study of the past and present situation and a through assessment of
the future prospects of the various end user industries. A study of the consumption norms
for each end user industry in respect of the product for which forecasts are needed is also
made. However, provision should be made for changes in the norms as a result of
technological change or emergence of substitute products.
The end use approach enables customer industry wise demand forecasts and it
is easy to evaluate any discrepancy in the forecasts with the actual value. The method is
appropriate for intermediate industrial products such as steel and caustic soda.
Demand projections and estimates are made by agencies of government as
well as industry associations. Among the government agencies, the Directorate General of
Technical Development and the Planning Commission may be mentioned. Several
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Associations of manufacturers make estimates. In regard to small scale sector, the
Development Commissioner for Small Scale Industries, the National Small Industries
Corporation and the Small Industries Services Institute provide valuable market
information about projects and products. Several private consultants undertake market
surveys for the fee
The key elements of market appraisal, both informal as well as formal, are
(1) Consumer analysis, (2) Competitive environment analysis, (3) Preparation of marketing
plans, and (4) assessment of market potential and demand forecasting. These key elements
are discussed in detail in subsequent paragraphs.
3. FINANCIAL APPRAISAL
a. Introduction
Financial appraisal is concerned with assessing the feasibility of a new
proposal for investment for setting up a new project or expansion of existing productive
facilities. This involves an assessment of funds required to implement the project and the
sources of the same. The other aspect of financial appraisal relates to estimation of
operating costs and revenues, prospective liquidity and financial returns in the operating
phase. In appraising a project, the projects direct benefits and costs are estimated at the
prevailing market prices. This analysis is used to appraise the viability of a project as well
as to rank projects on the basis of their profitability. It may be noted that financial appraisal
is concerned with the measurement of profitability of resources invested in the project
without reference to their source.
For the purpose of appraisal it is necessary to make estimates relating to
working results in case of existing concerns, cost of the project and the means of financing.
Financial projections for a ten year period have also to be made.
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The latest balance sheet and profit and profit and loss account may be
analyzed with a view to ascertaining, whether the concern is under/over capitalized,
whether the borrowings raised are not out of proportion to its paid up capital and reserves,
how the current liabilities stand in relation to current assets, whether the gross block has
been properly depreciated and has not been shown at an inflated value, whether there is any
inter-locking of funds with associate companies and whither the concern has been
ploughing back profits into the business and building up reserves.
d. Sources of Finance
The usual sources of finance for a project are:
Equity capital, term loan, deferred payment, unsecured loans from promoters and internal
accruals in the case of an existing unit.
A balance has to be struck between debt and equity. A debt equity ratio of 1:1
is considered ideal but it is relaxed up to 2:1 in suitable cases. Further relaxation in debt
equity is made in the case of capital intensive projects. All long term loans/deferred credit
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are treated as debt while equity includes free reserves. Equity is arrived after deducting
carried forward losses in the case of an existing unit.
The norm for promoters contribution in the project is 22.5 percent of project
cost with a lower contribution for projects promoted by technical entrepreneurs. Normally
the promoters contribution should be brought in by way of equity capital. If unsecured
loans from promoters/directors form an integral part of the means of finance, it should be
assumed that they would not be withdrawn during the currency of the loan and do not carry
interest higher than that payable on institutional loans. Preliminary expenses incurred by
the promoter are included in promoters contribution.
It is important that no gap is left in financing patterns. Otherwise it will result
in delays in implementation of the project. A condition is stipulated by financial institutions
that the promoters shall arrange for funds to meet any over run in the cost of the project.
While the emphasis of the financial institution is on the viability of the project they
generally stipulate by way of security, a first legal charge on fixed assets of the company
ranking pari passu with the charge if any, in favour of other financing institutions.
e. Financial Projections
For the purpose of determining the profitability of the project and the ability
of the company to service its loans and give a reasonable return on the equity capital,
estimates of cost of the project, profitability, cash flow and projected balance sheets have to
be prepared in the proforma given for ten years. These are inter related and are prepared on
the basis of the estimated cost of the project, sources of finance envisaged and various
assumptions regarding capacity utilization, availability of inputs and their price trends and
selling price. The important assumption that should be scrutinized carefully before making
estimates are capacity build up, raw material cost, estimate of wages and salaries, cost of
utilities, estimate of administrative expense, selling price assumed and provisions made for
depreciation and statutory taxes. Verification of profitability is the core of proper appraisal
of the project. The entrepreneur may be naturally tempted to present a bright picture but it
is the task of financial appraisal to verify the estimates. It is to be ensured that the profits
projected are realistic. In case of new units, any sharp build up of capacity within a year or
two will be unwarranted especially if the product is new. The quantum of raw materials and
utilities estimated to be consumed to obtain a particular quality/quantum of end product is
the core of cost of manufacture estimates and should tally with the performance guarantees
furnished by the collaborators/machinery suppliers. In case of multi product firms, the
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product mix is decided on the basis of contribution of each product, utilization of plant
capacity as well as market. Annual increases in wages and salaries should be about 5
percent.
Repairs and maintenance will have to be provided keeping in view the type of
industry and the number of shifts to be worked. Depreciation of the fixed assets should be
provided as per income tax rules. The selling price should be fixed keeping in view the
present domestic price of the product. The profitability projections are closely linked to the
schedule of implementation. On the basis of profitability projections, cash flow and
projected balance sheets are prepared for a period of ten years.
4. ECONOMIC APPRAISAL
Aspects of Economic Appraisal
Economic appraisal of a project deals with the impact of the project on
economic aggregates. We may classify these under two broad categories. The first deals
with the effect of the project on employment and foreign exchange and second deals with
the impact of the project on net social benefits or welfare.
a. Employment Effect
While assessing the impact of a project on employment, the impact on
unskilled and skilled labour has to be taken into account. Not only direct employment, but
also indirect employment should be considered. Direct employment refers to the new
employment opportunities created within the project and the first round of indirect
employment concerns job opportunities created in projects related on input and output sides
of the project under appraisal.
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A project may be export oriented or reduce reliance on imports. In such cases
an analysis of the effects of the project on balance of payments and import substitution is
necessary. The assessment of project on the countrys foreign exchange is done in two
stages; first, balance of payments effects of the project and second, import substitution
effect of a project. The import substitution effect of a project measures the estimated
savings in foreign exchange owing to the curtailment of imports of the items of production
of which has been taken up by the project.
The analysis of net foreign exchange effect may be done for the entire life of
the project or on the basis of a normal year. If two or more projects are compared on the
basis of their net foreign exchange effect, the annual figure should be discounted to their
present value.
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2. Market Imperfections
Private costs and profits reflect social costs and benefits only under perfect
competition. Since markets were largely regulated and prices were administered earlier in
our country, resources used by private sector were under priced. The recent phenomenon of
deregulation which has freed several resource prices from control may lead in future to
near approximation of conditions in perfect competition. For instance, foreign exchange
rate is now determined by markets. Since 1991, the interest on debentures is not fixed by
government. In several markets regulation and administered prices are being lifted.
3. Externalities
The difference between private costs and benefits and social costs and
benefits arises mainly because of externalities. The divergence arises because of economic
effects a transaction has on third parties. The effects may be benefits or costs. A project, for
instance, when it creates infrastructural facilities like roads, the area adjacent may be
benefited. Such benefits are, however, not included in assessing the benefits arising out of
the project. Actually, such benefits are invariably under provided and subsidies may have to
be paid to ensure their provision. On the other hand, a project may have harmful
environmental effects. Such costs are not internalized and not paid for by consumers or
producer. As a result, costs are imposed on society which is not accounted for. The activity
in question may also be over-extended.
The problem of externalities relating to environmental effects received
impetus from the thesis propounded by World Bank that wise environmental policies may
often make poor countries less poor. Not only is sound environmental policy essential for
durable development but many of the policies that improve the environment will also
strengthen development. They are also powerfully re-distributive since it is often the poor
that suffer from environmental degradation.
The cure for poverty is development. Development may also cure some kinds
of pollution. Given the right technologies, developing countries can decouple some kinds
of pollution from economic growth with beneficial effects on the economy.
4. Redistribution
Strictly from the viewpoint of the project promoter or owner, it is of no
consequence as to how the projects benefits are distributed among society. But to society or
government, it is essential to have information as to who benefits from the investment in
various projects. For instance, industrial projects are put forward and promoted whether in
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private or public sector to alleviate poverty and improve income distribution. Our entire
five year plan has poverty alleviation as their basic objective. It is however, not appreciated
that the provision opportunities through industrial projects cannot be availed of by the poor.
The poor are unskilled and illiterate and do not have the skills that factory type of
employment demands. To benefit poor, the emphasis should be on provision of
opportunities through Grih Udyog or rural cooperatives and on repetitive tasks which
demand little skill, such as textile printing, assembly and agro-material processing. The
structure of investment should not be to elongate the productive process or make it indirect.
Our plans have not been able to relieve poverty because projects promoted are of the
factory type. They are not suitable for integrating poor into market oriented activity.
Social cost benefit analysis is a specialized subject.
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2. Industrial Credit and Investment Corporation of India
(ICICI)
Industrial Credit and Investment Corporation of India (ICICI) was established
on January 5, 1955, and commenced its operations on April 14, 1955. The main objective
of ICICI was to encourage and assist industrial investment in the private sector. Under its
Memorandum of Association, the ICICI was to accomplish its main objective by providing
medium and long-term loans in rupees and foreign currency, investment in equities,
underwriting shares and debentures issues, guaranteeing loans from other private sources,
and by providing managerial and technical assistance to enterprises. The main purpose for
which ICICI assistance is available is for the purchase of capital assets in the form of land,
building, and machinery. The ICICI also assists in planning and execution of an investment
proposal even from the very early stage.
The ICICI does not quote standard terms for loans and other financial assistance. Each case
is considered on its merit and decisions are made in the light of the risks involved, the
prevailing condition and practices of financial institutions, and the cost of ICICIs own
funds. According to the resources position, the composition of assistance has varied from
year to year. The forign currency loans constitute the major form assistance. In respect of
loans, a commitment charge at a marginal rate is levied on the undrawn portion of the loan.
Full interest accrues on the portions of the loan disbursed. Loans are granted for periods up
to 15 years.The rates of ICICIs underwriting commission are notified in the letter of
underwriting.
Since ICICI provides a major portion of its assistance in the form of foreign
currency loans, the pattern of assistance displays weight age in favour of industries which
require greater foreign currency credit. Some of the major industries which have received
assistance from the ICICI are chemical and petro-chemical industry, fertilizers, metal and
metal products, machinery manufacturing, and electrical equipments.
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Operating Aspects and Policies of Financial Institutions
The development banks and other term lending institutions have o perform
appraisal tasks before deciding whether the project is bankable and whether the required
finances can be sanctioned. The appraisal tasks basically include the verification of
assumptions relating to technology, market, organizational structure, financial viability, and
economic viability. More specifically the activities in the appraisal process can be
described as follows: (1) technical analysis, to determine whether the specification of
technical parameters is realistic and optimal.
(2) Commercial analysis, to determine whether product specification and
marketing plan and organizational structure are soundly conceived.
(3) Financial analysis, to determine whether financial costs and returns are
properly estimated and whether the project is financially viable.
(4) Social profitability analysis, to determine whether a project is worthwhile
from the point of view of society.
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Stage I- Pre-Sanction (by IDBI, ICICI) (Fig.2)
Enquiry
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Stage II- Post-Sanction up to Disbursement (Fig.3)
Discussion with promoters on important conditions to
be stipulated including the tentative terms of conversion
of a portion of rupee loan into equity. Preparing and
issuing letter of intent
Investigation of title
Examination of prospects
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Appointment of nominee
directors
Analysis of balance
sheets and working
results
Periodical inspections
Satisfaction of mortgage
Discussions with
Representatives of
Assisted concerns and
Nominee directors by
Way of follow- up
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Operating Aspects of Financial Institutions
(1) Before filling up the prescribed application form, it is advisable that the
entrepreneur meets the senior officials of the financial institutions and has a very frank
discussion on the pros and cons of setting up a particular project.
(2) Based on the discussions with the executives of the financial institutions the
entrepreneur should prepare a detailed project feasibility report.
(3) The application is then completed by the promoters/entrepreneur. The
application is considered completed if the entrepreneur has the required letter of intent,
clearance of the Capital Goods Committee for proposed import of equipment, and
clearance of the land allocated by the Government for setting up of the project.
(4) The application is then submitted to either one of the financial institutions or
to more than one institution.
(5) The receiving institution then makes a summary of the application as
received and along with its comments, puts it up for a preliminary view to the meeting of
the senior executives of all the institutions who meet once in a month.
(6) At the meeting one of the financial institutions (IDBI, IFCI, ICICI) is
appointed as the lead institution for carrying out the detailed scrutiny of the application.
(7) A team of officers with technical and financial background from the lead
institution is assigned the task of scrutiny of the application. They prepare a list of queries
on which further information is required. At the same time other financial institutions may
also send their list of queries to the lead financial institution. For this purpose the
entrepreneur should send copies of application forms to all the financial institutions to
avoid delay and bottleneck. The lead institution is not authorized to commit itself on behalf
of the other institutions and that each individual institution has the right to obtain any
information that it may desire, independent of the lead institution. The lead institution only
facilitates the entrepreneur so as to save time and labour.
(8) After the list of queries has been answered the representatives of the
entrepreneur are called for preliminary discussion.
(9) After the discussions, a site inspection is made jointly by the officers of all the
institutions to assess the location, level of development of the land, and the infrastructural
facilities available in the vicinity. A meeting may also be arranged with the local Electricity
Board, Municipality, etc. to assess the availability of utilities in the area.
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(10) After the visit to the site, the institutional representatives hold discussions
with the applicants representatives at the project office, where details of the information
submitted at the time of application are expected to be readily available. To expedite the
matter, it is advisable that the applicant has the following information ready at the time of
visit by the officers:
(a) Certificate of Government approval.
(b) Map indicating proposed land/site.
(c) Building and plant layout.
(d) Quotations of all the equipment suppliers.
(e) Detailed break- up of the proposed capital expenditure.
(f) Details of all the profitability assumptions.
(g) Any other detail regarding background of the promoters, management setup
and project details that have not been submitted along with the application but may be
required by the officers.
(11) Usually, the scope of the project, list of equipments, project cost, and
profitability estimates are finalized during the visit and tentative financial plan is also
worked out.
(12) The final decision regarding the financial aspects is taken by the
entrepreneur and the senior executives of the financial institutions.
(13) After a detailed scrutiny of all the information submitted by the applicant
and discussions with his representatives, the institutions officers prepare a full report of
their findings. This report, if necessary, may be put before a committee of experts.
(14) The lead institution prepares a memorandum and presents it either at the
Senior Executive Meeting (SEM) or at the Inter Institution Meeting (IIM) and at the
meeting each institution indicates the extent up to which it is willing to assist the company
and sharing so decided is communicated to the applicant by the lead institution, so that the
applicant can start follow- up action with the other institutions for their assistance.
(15) The memorandum placed at the SEM/ IIM is next placed before the Board/
Executive Committee of the lead institution to obtain legal sanction of the assistance. Some
of the other institutions obtain adequate copies of the memorandum from the lead
institution for placing before their own board while other institutions prefer to write out
their own memorandum for placing before their board. In the latter case, the applicant may
be called upon to submit some additional information.
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(16) The all India financial institutions provide the following type of financial
assistance:
(a) Underwriting of shares/debentures
(b) Direct subscription to shares/debentures
(c) Guarantee to equipment suppliers
(d) Long term loans
(17) After the respective boards of the institutions approve assistance to the
applicant, a letter of intent is issued which in a sense conveys willingness of the institution
to provide the assistance, subject to the terms and conditions listed above. The letter of
intent is not, however, a legal document and does not bind the institution to grant
assistance.
(18) The next step is formal acceptance of the terms and conditions by way of a
letter. The institutions take up processing of legal formalities which include the following
points:
(a) Finalization of share issue prospectus.
(b) Examination of the title deeds for creation of security in the institutions favour.
(c) Other relevant matters.
(19) Each institution has is own list of approved solicitors who examine the title
deeds on its behalf and provide assistance.
(20) Disbursement: It sometimes happens that while the deeds of agreement have
been signed, certain terms and conditions are yet to be fulfilled, e.g. the formalities for
creation of the security are yet to be finalized. In these circumstances, the institutions agree
to make an interim disbursement.
(21) During the period of implementation, the assisted company is required to
keep the institutions posted about the progress of the project. To facilitate reporting, a
standard form has been designed by the all-India financial institutions which are just
gaining popularity. During the period of implementation, the institutional representatives
may sometimes visit the project site to assess the progress.
(22) Follow-up: Consequent upon the completion of the project, the institutions
keep in touch with the company until the loan is fully repaid or as the institution holds
shares in the company. The assisted company is required to submit information on its
working, every quarter, on the prescribed forms.
(23) In addition, it is incumbent upon the company during the currency of the
institutional assistance to obtain approval of the institutions for the following:
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(a) Utilization of financial assistance from any organization.
(b) Creation of charge on any of its assets in favour of any other party.
(c) Issue of additional share capital in any form or manner.
(d) Change in the full-time directors remuneration.
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Risk Minimization
Risk minimization lies at the heart of Project Finance. Project Finance is providing
finance for particular projects, which are later repaid from cash flows generated by those
specific projects.
Risk Management
Risk Management is the process of Identification, Measurement, Monitoring and
Control and Mitigation of risks. Risk Management aims at Risk Minimization and not Risk
Elimination.
Risk
Risk is defined as a possibility of adverse impact on earnings and capital on account
of expected or unanticipated event. Risk and Time are opposite sides of same coin, for if
there were no tomorrow there would be any risk. Time transforms risk and the nature of
risk is shaped by time horizon.
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STEP TWO: RISK ALLOCATION
1. Risks, on identification, must be allocated to the appropriate parties who have the
financial ability to bear them.
2. Financiers look at allocating risks to such parties, who have an interest/stake in the
concerned project.
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Types of Risks
1. Completion Risk:
Design and Construction phase involves Completion risk.
Completion risk involves the risk of not completing a project on schedule due to time,
budget, or technological constraints. Such events lead to delay in loan repayment and debt
accumulation.
To minimize risk before lending..
a. Obtain completion guarantees from sponsors, requiring them to pay all debts if
completion is not on schedule.
b. Ensure significant financial interest of sponsors in the project to maintain their
commitment.
c. Ensure that the project is developed under the terms of fixed price and time, under the
supervision of reputed developers.
2. Resource Risk:
Operation Phase involves Resource risk- Risk of shortage of inputs to generate adequate
returns.
To minimize this kind of risk:
a. Experts reports must certify the existence of inputs.
b. Ensure long-term supply contracts for inputs as a protection against shortages or price
fluctuations.
c. Obtain guarantees for minimum input levels.
3. Operating Risks:
Operating risks are risks affecting cash flows and generation capacity of
projects, such as inefficiencies in operations, shortage of skilled labour etc.
Prior to lending, the risks can be minimized by ensuring that a reputed and
financially sound operator is in charge of the project.
During the loan period, detailed operations showing the utilization of acquired funds
should be prepared. This helps ensure that the funds are being utilized for permitted
operating costs only.
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4. Market/Off Take Risks:
Market/Off Take Risk is a type of risk of not finding a buyer at the fixed price
to generate adequate cash flows.
This kind of risk is minimized by entering into a forward sales contract with a
financially sound company.
5. Credit Risks:
Credit risk involves the repayment capacity of the borrower. This kind of risk
could be minimized if the financier obtains a certificate of satisfaction with regard to
experience, personnel, and financial soundness.
6. Technical Risks:
Technical risk involves the risk of technical difficulties in construction and
operation of the projects plant. It can be minimized by mostly adopting new proven
technologies.
7. Currency Risks:
Currency Risks involves depreciation in loan and revenue currencies causing
an increase in costs and decrease in cash flows. This risk can be minimized by entering into
suitable hedging contracts, matching the currencies of supply contracts.
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HISTORY OF SBI
State bank of India are traceable to the first decade of 19 th century, when the
bank of Calcutta, later renamed as bank of Bengal, was established on 2nd june 1806. It
remains the oldest commercial bank in Indian subcontinent and also the most successful
one providing various domestic, international and NRI products and services, through its
vast network in India and overseas.
The RBI, which is the central banking organization of India, in the year 1955,
acquired a controlling interest in the imperial bank of India and the imperial bank of India
was christened on 30yh April 1955 as the state bank of India. This acquisition of the
controlling interest was done pursuant to the provision of the state bank of India act 1955,
an act enacted by the parliament of India.
GROWTH OF SBI
State bank of India has often acted as a guarantor to the Indian
governments, most notably during Chandra Shekhars tenure as prime minister of India.
With more than 9400 branches and a further 4000 + associate bank branches, the SBI has
extensive coverage. State bank of India has electronically networked most of its branches.
The bank has one of the largest ATM network in the region. The state bank of India has had
steady growth over its history, though it was marred by the Harshad Mehta scam in 1992.
In recent years, the bank has sought to expand its overseas operations by buying foreign
banks. It the only Indian bank to feature in the top 100 world banks in the fortune global
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500 rating and various other rankings. According to the Forbes 2000 listing its tops all
Indian companies.
SBI TODAY
Today, state bank of India has spread its arms around the world and has a network
of branches spanning all time zones. SBIs international banking group delivers the full
range of cross border finance solutions through its four wings- the domestic divisions, the
foreign office division, the foreign department and the international service division.
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Survey Form of Project Finance
SHRI CHIANI COLLEGE OF COMMERCE & ECONOMICS
Survey for Project on Project Finance
NAME:
DESIGNATION:
SIGNATURE:
CONTACT NO:
1) Are you aware of Project Finance ?
Yes
No
No
Lengthy
4) Which bank would you like to prefer for taking finance for Projects?
Private
Public
Foreign
Flexible
Comments:
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Survey Report On Project Finance
1) Are you aware of Project Finance ?
Options : Yes
No
No
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3) Do you think procedure for project finance is?
Options: Convenient
Lengthy
4) Which bank would you like to prefer for taking finance for projects?
Options: Private
Public
Foreign
Flexible
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Conclusion
Project Finance gives a brief overview of the common risks and methods of risk
minimization employed by financiers in project finance transactions. As stated previously,
each project financing is different. Each project gives rise to its own unique risks and hence
poses its own unique challenges. In every case, the parties - and those advising them - need
to act creatively to meet those challenges and to effectively and efficiently minimize the
risks embodied in the project in order to ensure that the project financing will be a success.
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Bibliography
1. I referred to a book naming Project Finance by author H.R. Machiraju
2. I referred also to a book naming Project Planning, Financing, Implementation, and
Evaluation by U.K. Srivastava
3. www.google.com
4. www.statebankofindia.com
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