Project finance

The project finance is tailored to meet the needs of a specific project. Repayment of the financing relies on the cash flow and the assets of the project itself. The risks (and returns) are borne not by the sponsor alone but by different types of investors (equity holders, debt providers, quasi-equity investors).  Because risks are shared, one criterion of a project's suitability for financing is whether it is able to stand alone as a distinct legal and economic entity. Project assets, project-related contracts, and project cash flows need to be separated from those of the sponsor.

Advantages and disadvantages OF project finance

In the appropriate circumstances, project finance has two important advantages over traditional corporate finance:

  1. increase the availability of finance; and
  2. reduce the overall risk for major project participants, bringing it down to an acceptable level.

For a sponsor, a compelling reason to consider using project finance is that the risks of the new project will remain separate from its existing business. Then if the project, large or small, were to fail, this would not jeopardize the financial integrity of the corporate sponsor's core businesses

On the contrary, it has rigorous requirements. To attract such finance, a project needs to be carefully structured to ensure that all the parties' obligations are negotiated and are contractually binding. Financial and legal advisers and other experts may have to spend considerable time and effort on this structuring and on a detailed appraisal of the project. These steps will add to the cost of setting up the project and may delay its implementation.

MITIGATING MAJOR PROJECT RISKS

Identifying the project's risks and then analyzing, allocating, and mitigating them are the essentials of project financing.

A project is appraised to identify its risks and to assess its technical and environmental feasibility (that is, whether it will function as expected), along with its financial and economic viability (that is, whether it will generate sufficient cash flows to repay debts and produce a satisfactory rate of equity return).

Commercial risks consist of:

  1. project-specific risks connected with developing and constructing the project, operating and maintaining the assets, and finding a market for the output, and
  2. broader economic environment risks related to interest rate changes, inflation, currency risk, international price movements of raw materials, and energy inputs, all of which have a direct impact on the project but are beyond the control of the project sponsors.

Noncommercial or policy risks are:

  1. project-specific policy risks arising from expropriation, changes in the regulatory regime, and the failure of the government or its public enterprises to meet contractual obligations; and
  2. political risks resulting from events such as war or civil disturbance.