1.5 The Theory of Project Finance
1.5.1 Separate Incorporation and Avoidance of Contamination Risk
Under normal circumstances, an already-in-place company that wants to launch a new investment project wouldWnance it on balance sheet. As a result, the project will be incorporated in the company’s business and the relative increase in the value of its assets will depend on the size of the new project as compared with the rest of the company’s assets.
Once the project is up and running it will generate cashXows and will be able to provide a return on the capital employed, which it is assumed equalsr.
But because this is a new project, company management is faced with the problem ofWnancing the new venture. In an already-in-place company, coverage wouldWrst and foremost come from cashXow generated by already-existing business or by recourse to new debt or by raising fresh equity. On the contrary, as seen in Section 1.2, project Wnance involves the separation between an existing company (or more than one, as is often the case) and a new industrial project.
Naturally each option has a cost for the company. In the case of self-Wnancing and equity this will be cost of equity (ke), whereas in the case of debt the cost of this is (kd).
The diVerence between the twoWnancing strategies is shown in Figure 1-3.
We assume that the cost of equity can be estimated using the standard CAPM (capital asset pricing model):
ke¼rf þ(rmrf)b
In the equation, the excess return for the stock market is measured by the expression (rmrf), in which rm is the return for a general stock exchange index calculated over a long period andrf is the risk-free rate for government securities. So, for instance, if it is assumed that the eVective return for 5-year government securities is 4.5%, the excess return for the stock market is 5%, and stock risk (b) equals 0.8, then the net cost of capital will be 8.5%, that is, 4.5 points of risk-free return and a 4-point risk premium.
The cost of debt (kd) can be calculated as the weighted average of the eVective cost of the various loan facilities used by the company on which interest is explicitly
Total risk Allocation to
SPV counterparties through operating contracts (Chapter 3)
Allocation to insurers
(insurance policies) (Chapter 4)
Residual risk borne by the SPV
Final loan/bond pricing
F I G U R E 1-2 The Risk Management Process in Project Finance
The Theory of Project Finance 11
charged. If, for instance, the company utilizes only an overdraft facility with an eVective cost of 10% and a mortgage loan with a cost of 8% and the respective percentages of the company’s total borrowings are 70% and 30%, then kd can be calculated as follows:
kd ¼ bkcof pcof þkmort:pmort:c (1t)
¼ð10%70%þ8%30%Þ (10:33)¼6:30%
The weighted average is multiplied by (1 – 0.33), where 0.33 is the corporate income tax rate given the tax deductibility of interests.
Given the weight of debt and equity in the company’s liabilities, a new invest- ment project concerning the company’s core business will cost it a weighted average of the cost of debt and cost of equity (or WACC—weighted average cost of capital):
WACC¼ke NC
NCþDþkd (1t) D NCþD
For ourWrm, the WACC using values forkd andke, respectively, of 6.30% net of tax and 8.5%, and a supposed weight of 50% for both equity and debt capital is 7.40%.
Assuming management intends to maximize the value of the company, it will go ahead with the new project if the return on the new initiative (r) is greater than the cost of resources required toWnance it (WACC), orrWACC.
It is reasonable to assume that when a companyWnances a new project on balance sheet (corporateWnancing), creditors and shareholders will establish the cost of new debt or cost of new equity based on two factors:
1. The soundness and proWtability of the venture that management intends to launch
2. The soundness and proWtability of the company that will realize the new venture (often the more important factor)
Assets in place
Share capital Existing debt
New project
New debt
New share capital
WACC
Cost of new debt
Cost of new equity Return on new
project
Return on existing
assets Assets
in place Share capital Existing debt
New project
New debt
New share capital
WACC
Cost of new debt
Cost of new equity Return on new
project Return on existing assets
Existing firm (sponsor/parent)
SPV
F I G U R E 1-3 Comparison of Corporate Financing and Project Financing Strategies
12 C H A P T E R u 1 Introduction to the Theory and Practice of Project Finance
This second assessment is the most critical for creditors. In fact, if the new venture were to fail and thus were unable to repay capital and interest, creditors could demand reimbursement from cash Xows generated by other, already-existing busi- ness. This would still be the case even if creditors were guaranteed by the new project’s assets and cashXow. Certainly such a guarantee would give them a prefer- ential right with respect to other company creditors. But it is also true that if the new project’s cashXow and assets were insuYcient to repay capital and interest, then they could still demand repayment from the remaining cash Xows produced by other company assets.
There are, however, cases in which the corporateWnance–based lending approach is not the best solution for realizing new projects.
Let’s suppose now that the new project shows features that are distinctive to projectWnance deals:
1. It is very large compared to the company’s current size.
2. It has a higher degree of risk than the average risk level for the asset portfolio in the balance sheet.
3. It is linked to the company’s own core business.
Factor 1 indicates that once the project comes on stream it will have a consider- able weight in terms of total assets (the sum of assets existing before embarking on the project and those concerning the project itself). In other words, the larger the project, the greater will be the increase in assets on the balance sheet. If the new project were to fail, its sheer size would jeopardize continuation of the company’s other business and value of remaining assets. This risk (often overlooked inWnancial theory) can be considered thecontamination risk.
Factors 2 and 3 can be understood by using a classic principle ofWnancial theory.
Suppose two projects (A and B) were to be recorded on the same balance sheet, each with a certain measure of risk. (Normal Wnancial practice is to utilize the standard deviation of expected returns for the two projects.) Then it is possible to establish the overall risk for the combination of these two projects. It is assumed thatr, the return on the project, is measured by ROI (return on investment, that is, the ratio between NOPAT—net operating proWt after taxes—and total assets employed by each of the two projects), respectively ROIAand ROIBfor Projects A and B.
The return for the combination of Projects A and B is equal to the sum of the average returns for the two projects weighted by the respective value of assets for each project in terms of total company assets. This would mean that
rAþB ¼ROIAAA AAþAB
þROIBAB AAþAB
whererAþB indicates the return on the company’s business asset portfolio, AA and AB, the value of assets invested, respectively, in Project A and in Project B. For example, if Project A has a value of 1,000 euros and Project B a value of 4,000 euros and an ROIAof 10% and an ROIB of 20%, then the return for the company’s asset portfolio will be
rP ¼ 10%1,000
1,000þ4,000þ 20%4,000
1,000þ4,000¼18%
The Theory of Project Finance 13
Instead the risk underlying the AþB portfolio is not the weighted average of risks for the two investments (which can be measured, for instance, using the standard deviation for returns rA and rB over an appropriate period). In eVect, if A and B concern operations in two very diVerent sectors (as, for instance, in the case of conglomerates with loosely linked strategies and very weak business synergies), the correlation between the two operations will be very low indeed. This means the trend for results of one project shed little or no light on the trend for the other.
InWnancial theory the risk for a two-operation portfolio can be calculated via the following equation:
sP¼ ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi s2Aw2Aþs2Bw2Bþ2sAwAsBwBrA,B q
in which wA and wB are, respectively, the weights of Projects A and B in the asset portfolio (in the example it is 20% for Project A and 80% for Project B),s2Aands2B are the variances for returns of the two investments, and rA,B is the correlation between the risk levels for A and for B.
For purposes of the example it is assumed that sA andsB are, respectively, 5%
and 20% and that the two businesses are negatively correlated by a factor of 0.
(Statistically, it is said that the two projects areindependent of each other.) In this case the portfolio risk is less than the simple weighted average of the two business risks:
sP¼ ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi 520:22þ2020:82þ25200:20:80
p ¼ 16:03%
However, the third assumption indicates that the diversiWcation eVect is not present. The new project is linked to the core business, and therefore the correlation between existing assets and new assets is very strong and positive.
At this point the three factors will be considered simultaneously, with the help of Table 1-2, which shows that Project B is large, has a higher risk than that of already- existing assets, but also has a higher return than on assets already available to management.
TABLE 1-2 Returns and Risks for Asset Portfolios with Varying Degrees of Correlation Between Projects Existing Assets
(Project A)
New Assets (Project B)
Market value 1,000 4,000
% on total value 20.0% 80.0%
Expected Return 10% 20%
Standard deviation (þ/) 5% 20%
Correlation CoeYcient
1 0 0.4 0.8 1
Expected return 18.0% 18.0% 18.0% 18.0% 18.0%
Risk (std deviation) 15.0% 16.03% 16.4% 16.8% 17.0%
14 C H A P T E R u 1 Introduction to the Theory and Practice of Project Finance
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.