In project finance, it is the future cash flow that becomes the basis for raising resources for investing in the project (Merna and Njiru 2002). Mills (1996) claims that, compared to other financing methods, predictability of cash flows is even more important because the lenders have limited or no recourse to the sponsor for repayment obligations of the SPV. The lender principally looks to the project’s cash flow as the source of repayment. Therefore, the focus should be mainly on the elements that influence cash flow.
Typically, the SPV does not concern itself with discounting, in- flation and deflation at the initial assessment. Economic parameters
calculated at this stage are in money terms only. The effects of discount- ing will be assessed by the lenders to adjust cash flows to present-day values. Different inflation rates will also be applied by lenders at dif- ferent cost and revenue centres, allowing the model to simulate the effect of inflation over different phases of the project.
Under project financing, a project is legally independent and thus lenders only have recourse to a project’s future cash flow and assets. It is this future cash flow that becomes the basis for raising resources for investing in the project. Lenders and investors will look at this cash flow before making any investment decision. Therefore, this cash flow needs to be tailored in a way that meets the needs of the project and at the same time is attractive to the potential lenders and investors.
A successful project financing significantly depends on the strength of the contractual commitments among various project participants.
These contracts are taken together and ensure lenders that there will be a reliable source of cash flow for repayment of the debt. Lenders estimating a project’s economics begin with estimates of construction costs and timings followed by operation and maintenance costs and the revenues generated by the project. Broadly speaking, a project may be said to pass through three major phases:
1. project appraisal 2. project implementation 3. project operation
Cash flow is defined by the sum of cash inflows and cash outflows through the project stages in a particular period. The cash flow of a project is the only source of income for the borrower. After servic- ing the debt, paying the dividends on equity, paying the coupon rate on bonds, spending for general operation and maintenance, and tax to the government, the borrower is left with either a surplus or a deficit.
The amount of surplus or deficit depends on the terms of repayment, the revenue generation capacity of the SPV and the risks involved in the project. A project can still be considered a risk until it crosses the break-even point. During the appraisal phase, the projected cash flows of a project would be the basis on which various contractual agree- ments with the parties involved are shaped and a decision whether to sanction the project is made.
36 Project Finance in Construction
–
£
Project appraisal +
Project implementation
Project operation
Time
Figure 3.1 Typical cumulative cash flow stages of a project (Merna and Smith 1994).
Cumulative cash flows, also known as net cash flows, are defined as the sum of cash flows in each fiscal year of the project. The cumulative flow for a particular year in the life cycle of the project is calculated by adding the net cash inflows with the net cash outflows. Cumulative cash flows can be used to determine surpluses or deficits within each period.
A typical cumulative cash flow curve for a project is illustrated in Figure 3.1. The precise shape of the cumulative cash flow curve for a particular project depends on variables such as:
❒ The time taken in setting up the project’s objective;
❒ Obtaining statutory approvals;
❒ Design finalisation;
❒ Finalisation of the contracts;
❒ Finalisation of the financing arrangement;
❒ The rate and amount of construction;
❒ Operational speed.
Negative cash flow, until a project breaks even, clearly indicates that a typical project needs financing from outside until it breaks even. The shape of the curve also reveals that in the initial phase of the project
less financing is required. As the project moves on to the implementa- tion phase, there is a steady increase in the finance requirement, which peaks at the completion stage. This point is defined as the cash lock-up in the project. The rate of spending is also depicted by the steepness of the curve. The rate of spending is often termed the ‘cash burn’, which is the rate at which cash is spent over a specified period; the steeper the curve, the greater the need for finance to be made available to the project. Once the project is commissioned and starts to yield revenues, the requirement of financing from outside the project becomes less.
Finally, the project starts to generate sufficient resources for the op- eration and maintenance and also a surplus of cash. However, even after the break-even point, the project may require financing for short periods to meet the mismatch between receipts and payments (Merna and Njiru 2002).
In project financing, it is this future cash flow forecast that becomes the basis for raising resources for investing in the project. It is the job of the finance manager of the project to package this cash flow in such a way that it meets the needs of the project and at the same time is attractive to potential agencies and individuals willing to provide re- sources to the project for investment. In order to achieve this objective effectively, a thorough knowledge of the financial instruments and the financial markets in which they are traded is essential.
Project finance is dependent on the revenues of a project (the project’s cash flow) to repay loans without affecting the balance sheet of the organisation. In the case of default in project finance, lenders have only recourse to the project facilities and to the main organisation.
Project finance is a key factor in the successful development of infrastructure projects. Project finance provides an alternative source of finance to cash-starved governments to provide infrastructure to sustain economic growth.
Within project finance, raising the finance is an important issue.
Without finance the project cannot go ahead. Therefore, the borrower needs to determine the sources of finance available.
Each of the instruments discussed has a claim on future revenue generation. The seniority of these instruments, in terms of their claim on project assets, in the event of default is illustrated in Figure 3.2.
Debt is the most used instrument to fund projects. With debt there is an interest charge on the loan. Bond issues are becoming popular
38 Project Finance in Construction
Debt (senior)
Mezzanine/bonds
Equity (junior)
Figure 3.2 Seniority of financial instruments (Merna and Faisal Fahad Al-Thani 2008).
amongst borrowers to raise project finance. Projects have been funded worldwide partly by bonds. Equity is considered risk capital because investors bear a higher degree of risk than other lenders. Equity ranks the lowest in terms of its claim on the assets of the project.
Debt is structured to meet forecasted cash flows to allow debt service. Typically, this is achieved by sculpting the debt repayments against forecasted cash inflows.
Chapter 4