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Sikkim Manipal University - MBA - PM0012 - Project Finance & Budgeting

Semester: 3 - Assignment Set: 2

Question 1: List the advantages and disadvantage of project finance.

Answer:

Nevitt and Fabozzi (2000) define Project Financing as ‟Financing of a particular economic unit
in which lender is satisfied to look initially at the cash flow and earnings of that economic unit,
as the source of funds from which a loan will be repaid, and at the assets of the economic unit
as collateral for the loan”.

International Project Finance Association (IPFA) defines project finance as “the financing of
long-term infrastructure, industrial projects and public services based on a non-recourse or
limited recourse financial structure, where project debt and equity used to finance the project,
are paid back from the cash flow generated by the project”.

The project, its assets, contracts, internet economies, and cash flows are separable from its
promoters or sponsors and are used to permit credit appraisal independent of the financial
strength of the sponsors. Attractiveness of the project finance lies in its ability to fund projects
off balance sheet, with limited or non-recourse to the equity investors. If project fails and they
are unable to pursue equity investors for liability, lenders recourse is to take ownership of the
actual projects.

Advantages and Disadvantages of Project Finance:

Project finance entails significant countervailing benefits to offset the incremental transaction
cost and time. Yet, the academic practitioner fails to understand and accurately depict these
benefits. As it is true that leverage raises expected equity returns, the motivation for using
project finance fails to recognize the fact that higher leverage also increases equity risk and
expected distress costs. However, it is argued that project finance solves two financing
problems:

 Reduces the cost of agency differences inside project companies.


 Decreases the opportunity cost of underinvestment due to leverage and incremental
distress costs in sponsoring firms.

The major advantages of project finance are:

 Allows the promoters to undertake projects without exhausting their ability to borrow
amount for traditional projects.
 Limits financial risks to a project to the amount of equity invested.
 Enables raising more debts as lenders are sure that cash flows from the project will not
be siphoned off for other corporate uses.
 Provides stronger incentives for careful project evaluation and risk assessment.
 Facilitates the projects to undergo careful technical and economic review.
 Eliminates the dependency on alternative nature of funding a project.
 Facilitates the arrangement of liability financing and credit improvement, accessible to
the project but unavailable to the project sponsor.
 Enables the diversification of the project sponsor‟s investments to reduce political risk.
 Gives more incentive for the lender to cooperate in an atmosphere of a troubled loan.
 Enables to have prolonged credit opportunities.
 Matches specific assets with specific liabilities.

Bhupinder Singh Reg. No. 521063004 Page 1 of 7


Sikkim Manipal University - MBA - PM0012 - Project Finance & Budgeting

Semester: 3 - Assignment Set: 2

Project finance2 primarily benefits sectors or industries where, projects are structured as a
separate entity, apart from their sponsors. Let us take the example of a stand-alone production
plant. This is assessed in accounting and financial terms separately from the sponsors‟ other
activities. Generally, such projects tend to be relatively huge because of the time and other
transaction costs involved in structuring, and because of the considerable capital equipment
that needs long-term financing. In the financial sector, by contrast, the large volume of finance
that flows directly to developing countries' financial institutions has continued to be a part of
the usual corporate lending kind.

All these do not mean that Project Finance is devoid of any disadvantages.

The major disadvantages of project finance are:

 Complexity of the process due to the increase in the number of parties and the
transaction cost.
 Expensive as the project development and diligence process is a costly affair.
 Litigious with regard to negotiations.
 Complexity due to lengthy documentation.
 Requires broad risk analysis and evaluation to be performed.
 Requires qualified people for performing the complicated procedures of project finance.
 Obligations regarding the trust fund account need to clearly specify.
 Higher level of control which might be exercised by the banks, which might bring conflict
with the businesses or contracts.

Question 2: List and explain in brief the various stages of capital budgeting.

Answer:

Capital budgeting process is largely related to financing, dividend and investment decisions of
the firm with a goal in mind. Corporate finance theory was designed with the goal of
maximizing the market value of the firm, to its shareholders. It is also known as shareholder
wealth maximization. Capital budgeting is related to investments in long term assets. ‘Capital’
refers to fixed assets used in production. ‘Budget’ refers to the plan of inflows and outflows
during some period. ‘Capital Budget’ refers to a list of planned investment outlays for different
projects. Therefore, capital budgeting is a process of selecting viable investment projects.

Funds are invested in both short-term and long-term assets. Capital budgeting is mainly
pertained with sizable investments in long-term assets. These assets may comprise tangible
items like property, plant and equipment. Assets may also consist some of the intangible items
such as new technology, patents or trademarks. One can distinguish the capital investment
project from recurrent expenditures by two features. One of the features of capital investment
projects is that they are significantly large. These are generally long-lasting projects with their
benefits or cash flows spreading over many years. Sizable, long-term investments in both these
assets have long-term consequences.

Various stages of capital budgeting:

Bhupinder Singh Reg. No. 521063004 Page 2 of 7


Sikkim Manipal University - MBA - PM0012 - Project Finance & Budgeting

Semester: 3 - Assignment Set: 2

 Identification - Identify which types of capital expenditure projects are necessary to


achieve the organization's goals, objectives, and strategies.

 Search - Explore several different capital expenditure investment alternatives that have
the capacity to achieve the organizational objectives and strategies.

 Information-acquisition - Analyze the predicted costs and consequences of the


alternative capital investments. Information should be both qualitative and quantitative.

 Selection - Choose projects for implementation. If there are several suitable projects, this
could require ranking projects in terms of priorities. A single project hurdle rate is chosen
and used to discount the costs and benefits of the various projects, thereby allowing
management to compare the projects.

 Financing - Obtain project finances. Determine whether internal financing (cash flow from
operations) or external financing (debt or equity) is necessary. In large organizations, this
is the responsibility of the treasury department.

 Implementation and control - Initiate selected projects and monitor performance. This
should include making sure the project is on time and within budget, and should be
followed up by a post-investment audit.

Question 3: Classify projects based on the ways they influence investment decision
process.

Answer:

Certain projects are sensitive on the basis of the degree of technical and human difficulty. The
technical difficulty involves dealing with technology and related problems such as new and
innovative technology, management of technological development, risks and dependencies.
While the human difficulty (usually politics)resulting from the interests of internal and external
stakeholders or public, who influence the outcome of the project. The internal factors being
project resourcing, conflict management and agreement of client and suppliers on what is being
delivered as per contract.

Investment projects are classified into three categories on the basis, of the way they influence
the investment decision process: independent projects, mutually exclusive projects and
contingent projects.

Independent projects:

An independent project is one, where the acceptance or rejection does not directly eliminate
other projects from consideration or affect the likelihood of their selection. For example, if
management plans to introduce a new product line, as well as, replace a machine which is
currently producing a different product. These two projects can be considered independent of
each other, if there are sufficient resources to adopt both, provided, they meet the firm’s
investment criteria.

Bhupinder Singh Reg. No. 521063004 Page 3 of 7


Sikkim Manipal University - MBA - PM0012 - Project Finance & Budgeting

Semester: 3 - Assignment Set: 2

Mutually exclusive projects:

The mutually exclusive projects are projects that cannot be followed at the same time. The
acceptance of one prevents the substitute proposal from accepting. Most of them have ‘either
or’ decisions. You will not be able to follow more than one project at the same time. The
evaluation is done on a separate basis so that one that brings the highest value to the
company is chosen.

Contingent projects:

A contingent project is one where the acceptance or rejection depends on the decision to
accept or reject multiple numbers of other projects. Such projects may be complementary or
substitutes. Let us take the example of bio fuel plant cultivation in a large scale and the
decision to set up a bio fuel manufacturing unit. In this case, the projects are complementary
to each other. The cash flows of the plant cultivation will be enhanced by the existence of a
nearby manufacturing plant. Conversely, the cash flows of the manufacturing unit will be
enhanced by the existence of a nearby cultivation farm.

Question 4: If there is an initial investment of rupees 2000 and 4 years of positive


cash flow of rupees 900 each, the discount rate is 12%. What is the present value of
each cash flow?

Year Cash Flow


Y1 2000
Y2 900
Y3 900
Y4 900
Y5 900

Answer:

Present Value:

The present value rule -- the future is less valuable than the present. To make decisions now --
really the only kind we make -- it is useful to know the "present value" of future money.
Present value is the current dollar value of a future amount -- what would have to be invested
today (at a given interest rate over a specified period) to equal the future amount. What is a
dollar in the future worth? It depends on when it will be received and our current investment
opportunities.

Discounting - a method for determining present value. To arrive at a present value of future
money, we need a method that accounts for why current dollars are worth more than future
dollars. The mechanism for capturing these elements is the discount rate—the rate at which
future cash flows are discounted back to today’s dollars. The discount rate varies in a common-
sense fashion:

 If receiving cash flows now is important, the higher the discount rate.

Bhupinder Singh Reg. No. 521063004 Page 4 of 7


Sikkim Manipal University - MBA - PM0012 - Project Finance & Budgeting

Semester: 3 - Assignment Set: 2

 If the risk of not receiving future cash flows is high, the higher the discount rate.
 If inflation is expected to rise, the higher the discount rate.

The present value of a single cash flow can be written as follows:

PV = FVn / (1 + i)n
The present value (r initial principal)
FVn future value at the end of n periods
i the interest rate paid each period
n the number of periods

This means that if you know what a future payment will be, when it will be made and what
interest rate that we would be paid to achieve comparable future payments -- you can compute
that payment's present value! Armed with this basic formula, you can compute a present value
quite easily if you know what the future payment will be (or is expected to be), when it will be
made, and the discount rate applied.

Cash Discount Present


Year
Flow Rate Value
1 1200 12 1081.08
2 900 12 730.46
3 900 12 658.07
4 900 12 592.86
5 900 12 Total:534.11
3596.58

Question 5: Write short note on:


a) Payback period
b) Discounted cash flow

Answer:

a) Payback period

Payback period in capital budgeting refers to the period of time required for the return on an
investment to "repay" the sum of the original investment. For example, a $1000 investment
which returned $500 per year would have a two year payback period. The time value of
money is not taken into account. Payback period intuitively measures how long something
takes to "pay for itself." All else being equal, shorter payback periods are preferable to
longer payback periods. Payback period is widely used because of its ease of use despite
recognized limitations, described below.

The term is also widely used in other types of investment areas, often with respect to energy
efficiency technologies, maintenance, upgrades, or other changes. For example, a compact
fluorescent light bulb may be described as having a payback period of a certain number of

Bhupinder Singh Reg. No. 521063004 Page 5 of 7


Sikkim Manipal University - MBA - PM0012 - Project Finance & Budgeting

Semester: 3 - Assignment Set: 2

years or operating hours, assuming certain costs. Here, the return to the investment
consists of reduced operating costs. Although primarily a financial term, the concept of a
payback period is occasionally extended to other uses, such as energy payback period (the
period of time over which the energy savings of a project equal the amount of energy
expended since project inception); these other terms may not be standardized or widely
used.

The payback period is considered a method of analysis with serious limitations and
qualifications for its use, because it does not account for the time value of money, risk,
financing or other important considerations, such as the opportunity cost. Whilst the time
value of money can be rectified by applying a weighted average cost of capital discount, it is
generally agreed that this tool for investment decisions should not be used in isolation.
Alternative measures of "return" preferred by economists are net present value and internal
rate of return. An implicit assumption in the use of payback period is that returns to the
investment continue after the payback period. Payback period does not specify any required
comparison to other investments or even to not making an investment.

It is period is the period in which the total investment in permanent assets pays back itself.
This method lists the various investments that are ranked according to the length of their
pay-back period and the investment with a shortest payback period is preferred. The
payback period can be ascertained in the following manner:

Payback period = Investment


-----------------------
Flow/year Cash

b) Discounted cash flow:

All organizations face one constant constriction of making use of limited resources to meet their
unlimited ambitions. As the demand for higher shareholders‟ worth increases, the pressures on
these resources also increase in turn forcing the management to make rational decisions when
investing on resources. The project valuation technique ensures suitable cash flow statements
and proper usage of the resources.

Discounted Cash Flow (DCF) facilitates the evaluation process. DCF framework helps in
accessing the profitability of a proposed project. Commonly every project's value is estimated
using a discounted DCF valuation, and the one with the highest value, as measured by the Net
Present Value (NPV) is selected.

The evaluation involves estimation of the size and timing of all the incremental cash flows
obtained from the project. This analysis is crucial in determining the economic viability of a
proposed project and the estimated rate of return that the providers of the capital can attain.

In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or
asset using the concepts of the time value of money. All future cash flows are estimated and
discounted to give their present values (PVs) – the sum of all future cash flows, both incoming
and outgoing, is the net present value (NPV), which is taken as the value or price of the cash
flows in question.

Bhupinder Singh Reg. No. 521063004 Page 6 of 7


Sikkim Manipal University - MBA - PM0012 - Project Finance & Budgeting

Semester: 3 - Assignment Set: 2

Using DCF analysis to compute the NPV takes as input cash flows and a discount rate and gives
as output a price; the opposite process – taking cash flows and a price and inferring a discount
rate, is called the yield. Discounted cash flow analysis is widely used in investment finance, real
estate development, and corporate financial management.

Question 6: Total cost of project is 150,000Cr. Expected return of project amount is


34,000 Cr. What is the shortest payback period?

Answer:

The payback on an investment shows how long it takes for the investment to pay for itself.
Calculating the payback requires knowing the cost of the investment and the annual cash flows
from it. The calculation provides investors with an approximate date when the investment's
cash in-flows will pay for its cash out-flows. Payback is useful because it gives investors an idea
of when to expect to start making money on an investment.

Payback = Cost of project/Expected Annual Cash Inflows

Payback=150 000/34 000

=4.41 years

Bhupinder Singh Reg. No. 521063004 Page 7 of 7

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