19MS207 - PROJECT FINANCE

UNIT III Assessing Risks in Project Finance

8
Project Finance and Commercial Risks -Project Finance and Macroeconomic Risks-
Regulatory and Political Risks- Risk Mitigation Methodologies for Projects- PF Roles & Risk
Management -Risk takers/risk avoiders - Separation of roles - Phasing of roles - Managing
by contract- Estimation of Cost of Project- Estimation of Cash Flows of the Project,
Elements of the cash flow stream, Basic principles of cash flow estimation, Biases in Cash
Flow estimation- Evaluating IRR, NPV, Profitability Index, Pay-Back Period
UNIT I Project Finance: An Introduction 8
Introduction – Definition- Typical characteristics- Pre-requisites- Typical PF examples-
Project Management-The Project Finance Markets- Role of Advisors in Project Finance-
Project Development and Management- PF & corporate lending-PF & asset based lending-
PF & property lending

UNIT II Project Feasibility Studies and Valuing the Project 8

Concept of Capital Budgeting, Time Value of Money, Cost of Capital, Concept of Risk &
Return and calculation of required rate of return for a Project: Project Identification and
Feasibility Studies, Preliminary Screening, Analysis: Market, Technical, Financial, Economic
and Environmental Analysis-. Financial Estimates and Projections: Projection of Profit,
Projection of Cash Flow Statement, Projection of Balance Sheet.
 Project Finance and Commercial Risks

The term Commercial Risks / business risks refers to the possibility of a commercial
business making inadequate profits (or even losses) due to uncertainties - for example:
changes in tastes, changing preferences of consumers, strikes, increased competition, changes
in government policy, obsolescence etc. Every business organization faces various risk
elements while doing business. Business risk implies uncertainty in profits or danger of loss
and the events that could pose a risk due to some unforeseen events in future, which causes
business to fail.

For example, a company may face different risks in production, risks due to irregular supply
of raw materials, machinery breakdown, labor unrest, etc. In marketing, risks may arise due to
fluctuations in market prices, changing trends and fashions, errors in sales forecasting, etc. In
addition, there may be loss of assets of the firm due to fire, flood, earthquakes, riots or war and
political unrest which may cause unwanted interruptions in the business operations. Thus
business risks may take place in different forms depending upon the nature of a company and
its production.
Business risks can arise due to the influence by two major risks: internal risks (risks arising
from the events taking place within the organization) and external risks (risks arising from the
events taking place outside the organization)

Internal risks arise from factors (endogenous variables, which can be influenced) such as:
human factors (talent management, strikes)
technological factors (emerging technologies)
physical factors (failure of machines, fire or theft)
operational factors (access to credit, cost cutting, advertisement)

External risks arise from factors (exogenous variables, which cannot be controlled) such as:
economic factors (market risks, pricing pressure)
natural factors (floods, earthquakes)
political factors (compliance demands and regulations imposed by governments)
 Project Finance and Macroeconomic Risks

Macro risk is financial risk that is associated with macroeconomic or political factors. There are
at least three different ways this phrase is applied. It can refer to economic or financial risk found
in stocks and funds, to political risk found in different countries, and to the impact of economic or
financial variables on political risk. Macro risk can also refer to types of economic factors which
influence the volatility over time of investments, assets, portfolios, and the intrinsic value of
companies.

Macro risk associated with stocks, funds, and portfolios is usually of concern to financial
planners, securities traders, and investors with longer time horizons. Some of the macroeconomic
variables that generate macro risk include unemployment rates, price indexes, monetary policy
variables, interest rates, exchange rates, housing starts, agricultural exports, and even commodity
prices such as gold.
Models that incorporate macro risk are generally of two types. One type, used primarily by
stock traders and institutions, focuses on how short-term changes in macro risk factors impact
stock returns. These models include the arbitrage pricing theory and the modern portfolio theory
families of models.

The other models that incorporate macro risk data are valuation models or the closely related
fundamental analysis models. Used primarily by those focusing on longer term investments
including wealth managers, financial planners, and some institutional investors, these models are
examples of intrinsic value analysis. In such analysis, forecasts of future company earnings are
used to estimate the current and expected value of the investment being studied. Macro risk
factors include any economic variables that are used to construct these estimates.
Understanding that macro risk factors influence the intrinsic value of a particular
investment is important because when the factors change values, errors can be introduced
in the corresponding intrinsic value forecasts. Investors who follow the
Black Swan Theory may try to reduce the overall exposure of their investments to
different macro risk factors in order to reduce the impact of economic shocks. This may be
accomplished using commercial portfolio optimization tools or by using
mathematical programming methods.

Another way macro risk is used is to differentiate between countries as potential places to
invest. In this meaning, the level of a country's macro risk differentiates its level of
political stability and its general growth opportunities from those of other countries, and
thus helps identify preferred countries for investment either directly or through country or
regionally oriented funds. Such analysis of political risk is also used in the analysis of
financial derivatives such as credit default swaps and other sophisticated financial
products. International rankings of countries, often updated annually, provide insight into
their relative political and social stability and economic growth.
 Regulatory Risks

Definition: Regulatory risk is the risk of a change in regulations and law that might
affect an industry or a business. Such changes in regulations can make significant
changes in the framework of an industry, changes in cost-structure, etc.
 Political Risks

Political risk is a type of risk faced by investors, corporations, and governments that political
decisions, events, or conditions will significantly affect the profitability of a business actor or
the expected value of a given economic action. Political risk can be understood and managed
with reasoned foresight and investment.

The term political risk has had many different meanings over time. Broadly speaking,
however, political risk refers to the complications businesses and governments may face as a
result of what are commonly referred to as political decisions—or "any political change that
alters the expected outcome and value of a given economic action by changing the probability
of achieving business objectives".

Political risk faced by firms can be defined as "the risk of a strategic, financial, or personnel
loss for a firm because of such nonmarket factors as macroeconomic and social policies
(fiscal, monetary, trade, investment, industrial, income, labour, and developmental), or events
related to political instability (terrorism, riots, coups, civil war, and insurrection)." Portfolio
investors may face similar financial losses. Moreover, governments may face complications in
their ability to execute diplomatic, military or other initiatives as a result of political risk.
Macro-level political risk looks at non-project specific risks. Macro political risks affect all
participants in a given country. A common misconception is that macro-level political risk only
looks at country-level political risk; however, the coupling of local, national, and regional
political events often means that events at the local level may have follow-on effects for
stakeholders on a macro-level.

Micro-level political risks are project-specific risks. In addition to the macro political risks,
companies have to pay attention to the industry and relative contribution of their firms to the
local economy.[11] An examination of these types of political risks might look at how the local
political climate in a given region may affect a business endeavor.
 Risk Mitigation Methodologies for Projects

As project managers, we know that risk mitigation is a ‘thing’. We talk about mitigating
risk. We have a column on our risk logs for mitigation strategies. But what does it actually
mean? How do you do risk mitigation?

Here are 7 of the most common ways to mitigate risk: all approaches that will transfer to
your project in most cases.

1.Clarify The Requirements

What is it that you want to achieve with this project? Knowing that, and having true, deep
clarity about that, is a huge mitigating factor for risk. It eliminates all the ‘we didn’t know
what we were doing,’ and ‘you never said’ type risks that relate to scope.
Make full use of feasibility studies, workshops and user groups to test out the ideas before
making a full commitment. Agile techniques can ensure end users and clients are engaged
at every step of the way, feeding into the outcomes and making sure that what is delivered
is really what is wanted.
2. Get The Right Team
People introduce all kinds of risk to a project, largely due to their availability and skills. People
with inadequate skills make your project take longer because they are slower. People who aren’t
available when you need them also impact your project timescales.
If possible, ringfence the resources that you need into the team. This mitigates a lot of the people-
related risks. The highest priority projects should attract and retain the best resources in the
company

3. Spread The Risk

Don’t try and dump all the risk on one person or group. Yes, risk transference is a recognised and
useful risk management strategy, but it has to be used with caution. Mitigating your own risk by
dumping it on someone else isn’t always the best approach.

4. Communicate and Listen

There is another way that people add risk to a project: through their actions when they are
overlooked as stakeholders.
Communicate widely, consult widely and listen to the responses you get. These can help you
identify residual risks and strategies to engage more effectively with the stakeholders concerned.
5. Assess Feasibility
Make use of feasibility studies and prototypes to test out ideas and solutions before you move to a full
build. This is a simple way of de-risking a project because you can use this early stage as a test bed for
checking your concepts, methodology and solution.

6. Test Everything
Experienced project managers will tell you that when project timescales are under pressure, testing is
often the task that gets cut.

Don’t let that happen. Testing is an important part of making sure that your project risk is lower and
manageable. Testing helps flush out problems that might bring the project to a standstill later. Test
everything: training materials, implementation plans, and obviously software and the deliverables. Test
frequently and allow longer than you expect.
7. Have A Plan B

You’ve planned out everything and your risk mitigation strategies are all in place. And still you hit a
problem that you hadn’t foreseen. Don’t worry. It happens.

The best way to plan for the unplannable is to have alternatives in your back pocket. This could be:
Contingency funds
Float in the plan
Additional resources on standby
Options to break the project into segments and/or reduce scope

A Plan B isn’t something that you particularly set out to want to use, but it’s there as a cushion
should any of your risks materialise in ways that you didn’t expect or new risks come along that took
everyone by surprise.
 Project Finance Roles & Risk Management

Large-scale infrastructure projects running across the world play a major role for the
development of global economy. The execution of these projects comes along with risks that
need to be addressed efficiently. This is where project financing, also known as limited resource
financing, comes into the picture.

Project financing coupled with risk management is the key to the successful completion of a
project. Read this blog to learn more about risk management techniques and their application in
project financing.

What is project finance?

Project finance refers to the arrangement of financial support for a specific project, with the
purpose of gaining cash flow in the future. Mostly, large and complex operations such as oil and
gas explorations, dams, power plants and roads utilise project financing. The types of projects
considered for funding include:

Long-term infrastructure;
Industrial projects;
Public services with a non-recourse or limited recourse financial structure.
Risk in project finance

The direct financing of infrastructure and industrial projects typically includes the
following risks:

•In case the sponsor disagrees with the terms of the transaction, the financial institution
providing the funds can gain control of the project assets;

•The project generally encounters challenging social and environmental issues because
of its large and complex operations;

•Halting of project operations can lead to legal complications, posing a direct financial
risk, thereby threatening the success of the project;

•Furthermore, larger projects lead to exceeding budgets failing to set issues like:
o Delays in project delivery due to technical problems;
o Pre-exaggerated benefits not matching the larger strategy;
o Unavailability of financial resources;
o Multiple design reconstructions.
What is risk management?

A large portion of the above-mentioned risks can be avoided with a contemporary, end-
to-end integrated risk management system. A risk manager should be placed at the level
of an executive committee of a relevant organisation. Each company should include risk
management as a part of its operations to get an insight into the relevant risks with the
help of the following aspects:

Identifying risks
Accessing impact and probability
Mitigating risks
Calculating residual impact and probability
Re-classifying risks
Prioritizing risks
Risk management methods in project financing

It is essential that risk management is the foundation of all project engagement. Generally, the risk
manager on site is responsible for ensuring that risk management remains the focus. These are the
steps:

Risk identification– risk identification refers to the refining and re-organisation of risk
administration to transform the project, both realistically and profitably. The generic risk factors
include:
(Technological risk; Natural disasters; Cost overrun; Delay in project execution; Credit risk; Cash-flow
risk; Financial market risk; Political risks)
Risk assessment – risk assessment involves re-allocation of risks to parties in the form of a risk
matrix. This enables the management to better understand the major risk elements of a large
infrastructure.
Risk quantification – this signifies the mathematical calculation of risk measures. Risk
quantification enables us to calculate the expected loss of a loan.
 RISK TAKERS/RISK AVOIDERS/MANAGING BY CONTRACT

Risk taker investors are seeking for greater market uncertainty and market fluctuations, and
they often pursue short-term, growth investments in anticipation of a higher investment return.
Unlike value investors who are risk-averse, thus pursuing large-cap, U.S. stocks, risktaker
investors invest in small, caps, international stocks and emerging markets.

Risk avoidance is the elimination of hazards, activities and exposures that can negatively affect
an organization's assets. risk avoidance methodology attempts to minimize vulnerabilities
which can pose a threat. Risk avoidance and mitigation can be achieved through policy and
procedure, training and education and technology implementations.

When something goes wrong during project execution, a clear scope of services as well as a
reasonable schedule and price, as stipulated in the contract, are your firm’s first defense. In such
matters, the risk management department must defer to the expertise of the operations team. But
the rest of the contract is ultimately about risk transfer and mitigation, meaning both the risk
management and operations teams need to understand how terms in the contract can increase or
decrease risk to the firm.
 Estimation of Cost of Project

What is a cost estimate?

Project cost estimation is the process of predicting the quantity, cost, and price of the resources
required by the scope of a project. Since cost estimation is about the prediction of costs rather
than counting the actual cost, a certain degree of uncertainty is involved. This uncertainty arises
from the fact that the project scope definition is never entirely complete until the project has
been finished, at which point all expenses have been made and an accountant can determine the
exact amount of money spent on resources.
Why project cost estimation?

Different reasons: investment decisions, comparing alternative plans, budgeting, cost control,
and validation. Cost estimates are prepared to different ends throughout the project lifecycle.
Upfront, the goal is to provide input for investment decisions. The cost estimate is used to
determine the size of the required investment to create or modify assets. It is also during the
early phases that alternative plans are considered that need to be priced. The cost estimate is a
deliverable that serves the decision-making process at each gate of the project lifecycle.

Later in the project, the budget is determined from a more extensive cost estimate that also
serves as a baseline for project controls and earned value measurement. As such, it is
maintained up-to-date and in synchronization with the planned schedule. By comparing
expenses and progress information with the baseline estimate, an indication of the project’s
performance is obtained that allows the cost control and project management to steer the
project.
Types of estimates

The tools and techniques used to compile estimates vary widely per project type, phase and
size. Early on, when the level of scope definitions is premature, capacity scaling,
parametric and factor methods may be used. When the scope gets better defined and with
more detail, so do the estimates, but effective cost estimating also requires an understanding
of the work that needs to be carried out. While a number of advanced tools exist to assist the
estimating process in the determination of quantities, cost and hours, it is still a process that
requires judgment and experience to come to a confident result.
 CASH FLOW ESTIMATION BIAS

 CFs are estimated for many future periods.

 If company has many projects and errors are random and unbiased, errors will
cancel out (aggregate NPV estimate will be OK).
 Studies show that forecasts often are biased upward (overly optimistic
revenues, underestimated costs).
 WHY IS NPV THE BEST METHOD?

We have noted that almost all the difficulties are survived by net present value and that is
why it is considered to be the best way to analyze, evaluate, and select big investment
projects. At the same time, the estimation of cash flows requires carefulness because if the
cash flow estimation is wrong, NPV is bound to be misleading.

There are many methods for investment appraisal such as accounting the (book) rate of
return, payback period (PBP), internal rate of return (IRR), and Profitability Index (PI).

Before comparing NPV, let’s recapitulate the concept again. Net present value method
calculates the present value of the cash flows based on the opportunity cost of capital and
derives the value which will be added to the wealth of the shareholders if that project is
undertaken.
 Payback Period (PBP)

The payback period is an investment appraisal technique which tells the

amount of time taken by the investment to recover the initial investment or
principal. The calculation of the payback period is very simple and its
interpretation too. The advantage is its simplicity whereas there is two major
disadvantage of this method. It does not consider cash flows after the
payback period it also ignores the time value of money.
IRR is a prominent technique for evaluation of big projects and investment
proposals widely used by management of the company, banks, financial
institution etc for their various purposes. The calculation of an IRR is little
tricky. It is advantageous in terms of its simplicity and it has certain
disadvantages in the form of limitations under certain special conditions.

Profitability Index (PI) is a capital budgeting technique to evaluate the

investment projects for their viability or profitability. Discounted cash
flow technique is used in arriving at the profitability index. It is also known
as a benefit-cost ratio. Calculation of profitability index is possible with a
simple formula with inputs as – discount rate, cash inflows, and outflows.
PI greater than or equal to 1 is interpreted as a good and acceptable
criterion.