PROJECT FINANCE

1. PROJECT FINANCE R VENKATESH CHIEF MANAGER & FACULTY STATE BANK ACADEMY GURGAON

2. INTRODUCTION • With a view to harnessing advancements in S&T to economic development, GoI laid emphasis on industrialisation through successive Five Year Plans. • Rapid industrial development needed massive investment. • Prior to independence, there were no institutional arrangements for term finance.

3. INTRODUCTION • GoI, therefore, established the following financial institutions: • Indl. Finance Corporation of India (1948) • Indl. Credit & Inv. Corpn. of India (1955) • Indl. Development Bank of India (1964) & • Indl. Reconstruction Bank of India (1971) • Similarly, State Governments also established SFCs in their respective states.

4. INTRODUCTION • For long, commercial banks confined their lendings to meet WC requirements only and they did not play any active role in extending term finance. • However, with increasing proportion of Term Deposits in their deposit portfolio and the paucity of resources in the country, it was felt that banks could enter the field of term finance, in a role complementary to that of Term Lending Institutions.

5. PROJECT BACKGROUND • The purpose of term assistance is to meet a part of the capital expenditure of a project. • A project can be defined as ‘A scheme of things to be done during a specified period in future for deriving expected benefits under certain assumed conditions’. • A project may be in the nature of setting up a new industrial unit, modernisation, expansion, diversification and promotion of R&D.

6. PROJECT BACKGROUND • To set up a project, certain capital expenditure needs to be incurred in acquiring assets such as L&B, P&M and other infrastructural facilities like roads, water supply, railway sidings, etc., in addition to the Preliminary / Pre-Operative Expenses and margin on WC Limits. • Where promoters of a project are unable to meet the entire capital expenditure out of their own resources, Term Loans are sanctioned to supplement the promoters’ contribution.

7. PROJECT BACKGROUND • Promoters of an industrial project can constitute themselves into any of the following forms of business organisations to implement the project : Sole Proprietorship, JHF, Partnership, Co-operative Society & Joint Stock Company. • Our discussion of the subject would revolve around Joint Stock Company as promoter.

8. PROJECT BACKGROUND • The Promotion Stage is a crucial stage in the entire life cycle of a project. Promotion in relation to a project will comprise broadly the following functions: • I] Identification of a project • II] Feasibility investigation • III] Assembling the proposition • IV] Financing the proposition

9. I] Identification of a Project • The first step in the project promotion is the identification of a project. An industrial project originates as an idea in a promoter when he observes the existence of a potential market for a certain product. • The promoter, on the basis of his experience, background and ability, then considers the feasibility of manufacturing and marketing the product at a remunerative price. • There should be an unsatisfied demand.

10. II] Feasibility Investigation • A detailed feasibility study is a costly exercise. It is, therefore, desirable that, before it is undertaken, marketability of the product to be manufactured is firmly established. • There are agencies, specialising in market research, which conduct such market studies. Promoters may take advantage of their services. • A market study aims at assessing the aggregate demand for a product.

11. II] Feasibility Investigation • The promoter will now undertake the detailed feasibility investigation proper, comprising two feasibility studies: • i) The Technical Feasibility Study • ii) The Economic Feasibility Study

12. II] Feasibility Investigation- Technical Feasibility • Technical Feasibility Study covers the following aspects: • Location of the project • Lay-out of the Plant • Size of the Plant • Factory construction • Manufacturing process / Technology • Process Design • Product Design • Scale of Operation • Infrastructural facilities

13. II] Feasibility Investigation- Economic Feasibility • The prime objective of setting up a project is to derive a fair return on the investment. • Economic Feasibility Study, therefore, concerns itself with matching of economic resources with the physical requirements of a project and determining the viability of investment therein.

14. III] Assembling the Proposition- CoP & MoF • When a promoter is satisfied about the technical feasibility and economic viability of a project, the next task is to work out the Cost of the Project and the Means of financing it. • The Cost of the Project would broadly include: (a) L&B (b) P&M (c) Misc. Fixed Assets (d) Technical Know-how, Engg. & Consultancy fees (e) Preliminary and Pre-operative expenses (f) Provision for contingencies (g) Margin on WC Limits

15. IV] Financing the Proposition • Setting up of a project involves acquisition of Fixed Assets which facilitate the process of production. Fixed Assets have a relatively longer life and are generally not meant for resale. They are required to be retained over a period of time to exploit their productive potential. • C/A go through the operating cycle of RM, WIP and FG, which when sold bring in cash. This cycle is generally completed in a short period of less than one year.

16. IV] Financing the Proposition • Thus, investment in C/A is realised over a short term, while investment in Fixed Assets is long term in nature. • It is realised through surplus generated in the form of Net Profits, Depreciation and other non-cash write-offs. • As it takes a long time for the Fixed Assets to pay for themselves, the promoter should raise suitable long term funds to finance a project.

17. IV] Financing the Proposition • Keeping the foregoing in view, the promoter will explore the financial feasibility of the project by examining • a) The possible long term sources of finance • b) The feasible financial leverage • c) The expected return on the investment

18. IV] Financing the Proposition

19. IV] Financing the Proposition- Long Term Sources • The aggregate amount of finance raised for financing a project is referred to as Capital, comprising two components – (a) Owned Capital and (b) Borrowed Capital. • The other sources of long term funds are: (a) Capital Subsidy applicable to projects coming up in certain notified backward areas, and (b) Interest free sales tax loans offered by State Governments.

20. IV] Financing the Proposition - Financial Leverage • After considering availability of long terms sources of finance, the promoter will decide about a suitable financial structure for the Company. • It will depend upon the financial leverage envisaged in the combination of sources of finance under the two categories, viz., Owned Capital and Borrowed Capital. • Few projects can be financed entirely by equity or debt.

21. IV] Financing the Proposition - Financial Leverage • The divergent interests of debt and equity are brought into alignment by the concept of Debt / Equity gearing which determines the level of debt that can be supported by a given quantum of equity. • For this purpose, Debt means Funded Debt including all term liabilities and equity will include Share Capital and retained earnings, if available. • No standard D/E Ratio can be prescribed.

22. IV] Financing the Proposition- Return on Investment • The amount invested in a project can be recouped through annual cash flows, over a period of time. • In arriving at a financial plan for the project, a promoter will examine the attractiveness of the project, vis-à-vis alternative sources of investment. • The process which assists the management in such a task is collectively known as ‘Capital Investment Evaluation’.

23. IV] Financing the Proposition - Return on Investment • The most important and widely used Capital Investment Evaluation techniques are: • Pay-back Method • Net Terminal Surplus Method • Excess Present Value Method • Internal Rate of Return Method

24. IV] Financing the Proposition - Return on Investment • The object of Pay-back Method is to find out the period of time required for recovering the entire amount of investment made in a project. • The cash flows (Net Profit + Depreciation + Other non-cash write-offs) are compared with the outlay on the project to determine the pay-back period. Years to pay back would be: Total Investment Cash Flow per annum

25. IV] Financing the Proposition - Return on Investment • Net Terminal Surplus Method employs the concept of compounding which involves re-investing the simple interest earned each year along with the principal so that the principal grows each year by the amount of interest earned during the previous year and interest being calculated on the increased principal also grows. • Future Value = Principal x (1+i)

26. IV] Financing the Proposition - Return on Investment • Excess Present Value Method is based on the discounted cash flow technique and uses the concept of discounting which is just the opposite of compounding. • In discounting, we arrive at the Present value of a future sum to which the original amount (which we want to find out), invested at a particular compound rate of interest has grown. • PV = Future sum (1+i)

27. IV] Financing the Proposition - Return on Investment • Internal Rate of Return Method – It is that rate at which the sum of the discounted cash flows is equal to the investment outlay. In other words, IRR is the rate which makes the Present Value (PV) of benefits equal to the Present Value of costs or reduces the Net Present Value (NPV) to zero. The object of this method is to find the rate of return which a project is likely to earn over its useful life. • IRR =Lower Discount Rate + Diff. Between the two discount rates x NPV at lower discount rate Abs. diff. between the two NPVs.

28. Types of Term Assistance • The types of term assistance extended by the Bank can be broadly classified into: • I] Term Loans (Incl. Forex Loans) • II] Deferred Payment Guarantees • III] Bill Discounting Facilities • IV] Underwriting of Shares / Debentures

29. Types of Term Assistance-Term Loan • A Term Loan is a loan granted for a fixed term of not less than one year, intended normally for financing fixed assets acquired / to be acquired, carrying interest at a specified rate, and scheduled for repayment in instalments. • Depending on the term for which the said terms loans are granted, they could be classified into (a) Short Term Loans (b) Medium Term Loans and (c) Long Term Loans.

30. Types of Term Assistance-DPG • Deferred Payment Guarantee (DPG) is a contract to pay to the supplier the price of machinery, supplied by him on deferred terms, in agreed instalments with stipulated interest on the respective due dates in case of default in payment thereof by the buyer. • A DPG is, in many respects, a substitute for a Term Loan and, as far as the buyer of P&M is concerned, it serves the same purposes as a Term Loan. • Standards of appraisal are the same as TL.

31. Types of Term Assistance- Bills Discounting • Under a contract for sale of machinery on deferred payment basis, the balance remaining to be paid after the initial down –payment represents the deferred receivables of the seller. • Thus, the funds of the seller get blocked for unduly long periods and the seller requires finance against such deferred receivables to replenish his Working Capital.

32. Types of Term Assistance - Bills Discounting • To facilitate availment of finance against the deferred receivables, the seller usually draws a series of usance bills with graded maturities to coincide with the due dates of payment of the relative instalments (including applicable interest). • The usance bills drawn by the seller will be accepted by the buyer before they are discounted by the seller’s banker.

33. Types of Term Assistance- Underwriting of Shares • The necessity for underwriting arrangement arises only in the case of a Public Limited Company resorting to raise through the capital issue market, a part of the Share Capital for part-financing a project. • Underwriting is a contract whereby a person agrees, in consideration, to take up a specified number of shares or debentures or amount of debenture stock to be offered to the public, in the event of the public not subscribing for them.

34. Types of Term Assistance - Underwriting of Shares • Underwriting as a business will come under the scope of ‘Investment Banking’ as distinct from ‘Commercial Banking’. • In view of this, therefore, a high degree of selectivity should continue to be exercised in undertaking underwriting business. • However, the business stemmed not so much from the point of view of earnings on the investment as from the consideration that no viable project enjoying national priority should suffer for want of underwriting support.

35. Project Appraisal • The purpose of Project Appraisal is to ascertain whether the project will be sound – technically, economically, financially and managerially – and ultimately viable as a commercial proposition. • The appraisal of a project will involve the examination of: • a) Technical Feasibility : To determine the suitability of the technology selected and the adequacy of the technical investigation, and design.

36. Project Appraisal • b) Economic Feasibility : To determine the conduciveness of economic parameters to setting up the project and their impact on the scale of operations. • c) Financial Feasibility : To determine the accuracy of cost estimates, suitability of the envisaged pattern of financing and general soundness of the capital structure. • d) Commercial Viability : To ascertain the extent of profitability of the project and its sufficiency in relation to the repayment obligations pertaining to term finance.

37. Project Appraisal • e) Managerial Competency : To ascertain that competent men are behind the project to ensure its successful implementation and efficient management after commencement of commercial production. • A project should also be examined, wherever appropriate, from the point of view of its value to the national economy in terms of socio-economic benefits like generation of employment opportunities, forex earnings, the quantum of import substitution, etc.

38. Project Appraisal • The first step in Project Appraisal is to find out whether the project is prima facie acceptable by examining salient features such as: • The background and experience of the applicants, particularly in the proposed line of activity • The potential demand for the product • The availability of the required inputs, utilities and other infrastructural facilities • Whether the project is in keeping with the priorities, if any, laid down by the Government.

39. Project Appraisal • The original application may not contain all the basic data / information. In such cases, it may be necessary to interview the applicants and elicit all the necessary data / information with a view to forming an overall idea about the general feasibility of the project. • After satisfying itself about the prima facie acceptability of the project, the Branch should call for from the promoters, an ‘Application’, containing the following essential data / information, such as:

40. Project Appraisal • a) Particulars of the project along with a copy of the Project Report furnishing details of the technology, manufacturing process, availability of construction / production facilities, etc. • b) Estimates of cost of the project detailing the itemised assets acquired / to be acquired, inclusive of Preliminary / Pre-operative Expenses and WC margin requirements.

41. Project Appraisal • c) Details of the proposed means of financing indicating the extent of promoters’ contribution, the quantum of Share Capital to be raised by public issue, the composition of the borrowed capital portion with particulars of Term Loans, DPGs, Foreign Currency Loans, etc. • d) WC requirements at the peak level (i.e., when the level of Gross Current Assets is at the peak) during the first year of operations after the commencement of commercial production and the banking arrangements to be made for financing the WC requirements.

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

43. Project Appraisal • g) Demand projection based on the overall market prospects together with a copy of the market survey report. • h) Estimates of sales, CoP and profitability. • i) Projected P&L Account and B/S for the operating years during the currency of the Bank’s term assistance. • j) Proposed amortisation schedule, i.e., repayment programme.

44. Project Appraisal • k) Projected Funds Flow Statement covering both the construction period and the subsequent operating years during the currency of the Term Loan. • l) Details of the nature and value of the securities offered. • m) Consents from the Government / other authorities and any other relevant information.

45. Project Appraisal • In respect of existing concerns, in addition to this information, particulars regarding the history of the concern, its past performance, present financial position, etc., should also be called for. • The ‘Application’ completed in all respects and duly signed by the authorised signatories of the Company will form the basis for the detailed appraisal of the project.

46. Project Appraisal • An inspection of the project site (or factory in the case of existing units) is a must. • Each project has to be examined in proper perspective having due regard to its nature, size and scope. • Although the basic techniques employed for appraising the viability of various projects are more or less the same, there could be no standard or uniform approach for appraising all projects.

47. Project Appraisal • The ultimate objective of the appraisal exercise is to ascertain the viability of a project with a view to ensuring the repayment of the borrower’s obligations under the Bank’s term assistance. • Therefore, it is not so much the quantum of the proposed term assistance as the prospects of its repayment that should weigh with the Branch while appraising a project.

48. Project Appraisal • In project appraisal, nothing should be assumed or taken for granted. • All the data / information should be checked and, wherever possible, counter-checked through inter-firm and inter-industry comparisons. • It should be borne in mind that “Healthy scepticism is a cardinal virtue in project appraisal.”

49. Project Appraisal Memorandum

50. Project Appraisal Memorandum