1.5 The Theory of Project Finance
1.5.2 Conflicts of Interest Between Sponsors and Lenders and Wealth Expropriation
If we examine this case ex ante (that is, review the case before the new project is realized), we see that the company’s overall return will rise to 18%, an increase of 8 percentage points over the initial level of 10%. The forecast average return is the weighted average of returns for Projects A and B and is not aVected by any correl- ation between the two projects.
Instead as regards ex ante forecast risk, correlation has an important impact.
In the example, a potential range was assumed from a correlation coeYcient of1 to a coeYcient ofþ1. The negative extreme would represent projects diversifying from the core business, whereas the positive extreme would indicate projects that are perfectly synchronized with the trend for returns of Project A (the core business).
Observing the results, it is quite obvious that Factor 3 forces toward extreme results. Given a constant average return for the combination of Projects A and B of 18%, management will see company risk (standard deviation of returns) rise from 5%
for Project A alone to 15% (correlation1) or 17% (correlationþ1) for combined Projects AþB.
The signiWcant result caused by contamination risk should also be noted. Even if it were management’s intention to launch a new venture to diversify from the company’s core business (in which case the new project will have a negative corre- lation coeYcient), the risk for combination AþB will be higher than the original 5%
for Project A alone. This is easily understood, given that Project B is four times the size of Project A (contamination risk).
In eVect (still from an ex ante standpoint), if management wants to launch a new Project B and Wnances it on balance sheet, therefore combined with Project A, these company directors will have to bear in mind thatWnancers and shareholders will see the Project A þB combination as being riskier. They will be prepared to Wnance the new venture but not atkeandkd levels existing before embarking on the new project. The values ofkeandkdwill go up in order to compensate creditors and shareholders for the greater ex ante risk for the company incorporating the new project.
If the increase for the weighted average cost of capital (that is, the weighted average ofkeandkd) is greater than the increase for the company’s expected return (8%), then the strategy to Wnance the new venture on balance sheet will lead to a reduction and not an increase in the value of the company.
This conclusion is why large, risky projects are isolated by the sponsors in an ad hoc vehicle company, that is, oV balance sheet. Separation avoids the risk that Project B contaminates Project A, thereby increasing the weighted average cost of capital for both. Because project Wnance is indeed an oV-balance-sheet solution, it achieves this important result.
1.5.2 Conflicts of Interest Between Sponsors
However, separation is not necessarily always the best solution from the stand- point of creditors. Let’s assume that, for simplicity’s sake, management Wnances already-existing assets and those required for the new project with a single debt with a value at maturity of 100. Furthermore, it is assumed to be a zero-coupon debt and that the diVerence between 100 and the present value of the debt at the start of the project isWnanced by equity capital.
Management can decide to Wnance existing assets (Project A) and new project assets (Project B) separately by using a project Wnance approach, or they could Wnance the combined projects using a corporateWnance approach.
Now future cash Xows for existing and new project assets will be considered according to six possible scenarios. The situation is summarized in the Table 1-3.
In Solution 1 (corporate Wnance), cash Xows from Projects A and B are used jointly to repay the debt contracted for existing and new venture assets. As can be seen, the company defaults in Scenarios 1, 2, and 3, whereas it manages to make a positive payoV to shareholders in the remaining ones.
In Solution 2 (project Wnance), cash Xows for Project B are only used to repay debts for that project. If there is a positive diVerence, then Project B can pay dividends to Project A (its parent company).
As can be seen in Table 1-3, Project B is in default in Scenarios 1, 3, and 5; it manages to pay dividends to its parent company in the remaining scenarios.
TABLE 1-3 Example of Trade-off Between Contamination Risk and Loss of Coinsurance Effect
Scenario
Hypothesis 1 2 3 4 5 6
Debt Project A (assets in place) 100 100 100 100 100 100
Debt Project B (new project) 100 100 100 100 100 100
Expected cashXows Project A (assets in place) 50 50 130 130 300 300
Expected cashXows Project B (new project) 50 130 50 130 50 130
Solution 1:on-balance-sheetWnancing
Total cashXows Project AþB 100 180 180 260 350 430
Total debt Project AþB 200 200 200 200 200 200
PayoVcreditors 100 180 180 200 200 200
PayoVshareholders default default default 60 150 230
Solution 2:oV-balance-sheetWnancing
Total cash flows Project B 50 130 50 130 50 130
Total debt Project B 100 100 100 100 100 100
PayoVcreditors Project B 50 100 50 100 50 100
PayoVfor shareholders Project A (dividends) default 30 default 30 default 30
Dividends from Project B (X) 0 30 0 30 0 30
Total cashXows 1 (Y) 50 50 130 130 300 300
Total cashXow (XþY) 50 80 130 160 300 330
Total debt Project A 100 100 100 100 100 100
PayoVcreditors 50 80 100 100 100 100
PayoVshareholders sponsors default default 30 60 200 230
Source:Adapted from Brealey, Cooper, and Habib (1996).
16 C H A P T E R u 1 Introduction to the Theory and Practice of Project Finance
Project A (the parent company) can count on its own cash Xows and dividends paid by Project B to repay its own debts. Table 1-3 shows that Project A is only in default in the two unfavorable Scenarios, 1 and 2.
The following conclusions can therefore be drawn.
1. In Scenario 2, projectWnancing is the optimum solution because it avoids the damaging eVect of contamination risk from Project A. (Project A defaults but not the new project.)
2. In Scenario 3, projectWnancing is still the optimum solution, but for the opposite reason. In this case damage to existing assets as a result of contamination risk from Project B is avoided. (Project B is in default but not Project A.)
3. In Scenario 5, the projectWnancing solution is still optimal from the standpoint of Project A shareholders (the payoV is 200 instead of 150 in the corporate Wnance solution), however, not from the point of view of creditors, since Project A shareholders extract a value of 50 from lenders. In fact, if the project had beenWnanced on balance sheet, the remaining Project A cashXows would have avoided default of the project and enabled full repayment of creditors. In other words, in Scenario 5 there is no longer a coinsurance eVect of the company as regards the project, and vice versa.
To summarize, in our example, separation of the company and the project is always the optimum solution from the shareholders’ standpoint and can cause wealth expropriation from creditors. However, management must always assess the trade-oV between the beneWts gained by separating the two projects and the disadvantages due to the loss of the coinsurance eVect created between company and project. While from a purely theoretical standpoint it will always be useful for sponsors to separate new projects from existing companies, if a new venture defaults it will have a sign- iWcant impact on the sponsors’ reputation and could lead to negative consequences with regard to the cost of new debt contracted (kd) toWnance additional new projects.
In certain situations, therefore, the coinsurance eVect might be preferable to beneWts for shareholders as a result of company–project separation.
The Theory of Project Finance 17
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C H A P T E R
u2
The Market for Project Finance:
Applications and Sectors
Introduction
The focus of this chapter is the projectWnance market. Here we present:
1. The historical evolution of the sector and of market segments in an inter- national context, distinguishing between various macro areas at a global level 2. A detailed look at the European market and public–private partnerships
(PPPs)
The data presented here are taken from the Thomson One Banker databank, and they refer to loans granted for projectWnance transactions. Bond issues, which are speciWcally addressed in Section 6.11, are not included.
Section 2.1 focuses on the historical evolution of project Wnance worldwide;
Section 2.2 presents market data. Details on the European context and PPP initia- tives are given in Sections 2.2.1 and 2.2.2, respectively.