Long-term financing of Projects Debt Mr. D.K.Goswami Choice International Limited 12 November 2011 1
Flow of Presentation Meaning of the word Project and its types Cost of Project Setting-up of a Project Means of Finance Return on Investment - Debt v/s Equity Financial Ratios Risk Analysis & Mitigation Project Appraisal Areas of interest for Stakeholders Role of Debt in Infrastructure Sector Conclusion 2
Meaning of the word Project Meaning Making an initial Investment; For earning the desired rate of return. Project Types: Greenfield Project Ideation; Planning and Design; Use of raw materials, men and machinery to produce and sell Finished Goods. Brownfield project - Land and infrastructure already in place;. Project expansion Horizontal expansion (diversification of project); Vertical expansion (creation of new capacity). 3
Cost of the Project Types of Cost Hard cost - Purchase of land, building, plant & machinery. Soft cost - Interest incurred during pre-construction period, margin for meeting working capital requirements, other costs (preliminary expenses, pre-operative expenses, brokerage and finder fee, overheads, etc). Social cost (also known as non-financial cost); The challenge is how to capture the cost in financial terms, To identify who bears the ultimate burden of social costs Exploitation of non-renewable sources of energy (Coal, Petroleum, Iron ore, Oil and Natural Gas) Exploitation of other resources - air, water, plantations, etc. Resettlement and rehabilitation cost Benefits of recycling. 4
Setting up of a Project The setting-up of a project requires a sequence of steps to be completed in a phased manner; the same are illustrated below. 5
Key terms Meaning of certain key terms: Equity - It is the capital amount which is raised by members of a company representing ownership interest. Quasi equity - It is a category of debt taken on by a company that has some traits of equity such as flexible repayment options or being unsecured. For e.g. Mezzanine debt, subordinate debt. Senior debt - A class of debt that has priority with respect to interest and principal over other classes of debt and over all classes of equity by the same issuer. In the event of financial difficulties or liquidation of the borrower's assets, holders of senior debt will have a priority claim. Junior debt - It is debt that is either unsecured or has a lower priority than of another debt claim on the same asset or property. It is also called as subordinated debt. 6
Means of Finance DEBT Borrowing money to be repaid, plus interest. No dilution of ownership Principal and interest are known, can be forecasted in advance. Few compliance requirements Lender has no claim to future profit of business. EQUITY Raising money by selling interests in the company. Dilution of ownership No such forecasting possible, since dividends depend on the present earnings and future expansion plans Requires compliance with security laws and regulations Lender has claims to profits of the business 7
Return on Investment - Debt v/s Equity Case I : In case of profit Total Funds employed : INR 100 lacs (Rs in lacs) Particulars (I) 100% Equity (II) 50% Equity 50% Debt (III) 20% Equity 80% Debt EBIT (Profit) 100 100 100 Less: Interest @ 10% 0 5 8 EBT 100 95 92 Less: Tax @ 30% 30 28.5 27.6 PAT 70 66.5 64.4 EPS (FV Rs. 10) 7 13.3 32.2 8
Return on Investment - Debt v/s Equity Case II : In case of loss Total Funds employed : INR 100 lacs (Rs in lacs) Particulars (I) 100% Equity (II) 50% Equity 50% Debt (III) 20% Equity 80% Debt EBIT (Loss) (100) (100) (100) Less: Interest @ 10% 0 (5) (8) Loss before Tax (100) (105) (108) Less: Tax @ 30% 0 0 0 Loss after tax (100) (105) (108) 9
Return on Investment Project Internal rate of return (IRR) The discount rate that makes the net present value of all cash flows from a particular project equal to zero. The project IRR takes as its inflows the full amount(s) of money that are needed in the project. The outflows are the cash generated by the project. NPV = CF 1 Sum of [CF N / (1+IRR) N ] Equity IRR Equity IRR is essentially the "leveraged" version of project IRR. The inflows are the cash flows required (-) any debt that was raised for the project. The outflows are cash flows from the project (-) any interest and debt repayments. To calculate equity IRR, we need to determine Free Cash flow to equity (FCFE). FCFE= Net income + Non-cash charges to the income statement - net Working Capital requirement - Capital exps - long-term investments - net debt repayment 10
Return on Investment Debt IRR Inclusion of debt generally changes the project IRR, albeit marginally. Increases the cost of the project, so initial outflow goes up Provides tax benefits as interest can be capitalized Inclusion of debt increases equity IRR because of tax shield which is interest payment Value Creation for shareholder: Debt does not dilute the owner's ownership interest in the company. Interest on debt is tax deductible, lowering the actual cost of the loan to the company. 11
Financial Ratios Interest coverage Ratio determining ability to pay interest on debt. Lower the ratio, the more the company is burdened by debt expense Interest coverage ratio = EBIT / interest expense When a company's interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable. Debt service coverage (DSC) Ratio of cash available for debt servicing to interest, principal and lease payments. DSC Ratio = (Annual Net Income + Amortization/Depreciation + Interest Expense + other non-cash and discretionary items (such as non-contractual management bonuses)) / (Principal Repayment + Interest payments + Lease payments This ratio should ideally be over 1. 12
Project IRR v/s Equity IRR Scenario 1 Project IRR is lower than Interest rates It would not be feasible to take-up the project, because of higher interest rates that would be required to be paid on debt, which means reducing equity holders' profit by paying a part of it to the debt holders as Interest. Scenario 2 Project IRR is higher than Interest rates In scenario 2, which is the most likely cases in all the projects that you would start, your interest rate will be lower than the project IRR, which means there would be a bigger share available for Equity shareholders, as they would be in a position to leverage their position using debt and generate extra cash. Please refer to illustration on the next page. 13
Illustration Total Funds employed : INR 100 lacs Interest rate: 10% Project IRR : 20% Assume no taxes. (Rs in lacs) Particulars (I) 100% Equity (II) 50% Equity 50% Debt EBIT (Profit) 20 20 Less: Interest @ 10% 0 5 EBT 20 15 Project IRR 20% 20% Equity IRR 20% 30% 14
Risk Analysis and Mitigation Type of Risk Political Risk Meaning Risk Analysis Risk Mitigation Risk due to nonmarket factors macroeconomic / social policies Project-specific risks (Micro-level risk) Political changes Political instability Terrorism, civil war, riots Customized analysis (in depth reporting) Political Risk insurance Contingency plan Due diligence Political leverage Business Risk Risk of inadequate cash flow to meet operating expenses Risk of Business Failure Employee strikes Changes in Management Decision making Market Position Technology obsolescence Diversification Quality Management Flexibility in process Control & Ownership Documentation procedure Risk transfer clause 15
Risk Analysis and Mitigation Type of Risk Financial risk Meaning Risk Analysis Risk Mitigation Risk associated with financing, including financial transactions. Credit risk Market risk Liquidity risk Operational risk Model risk Hedging (Selection of combination of assets to offset the movements of each other e.g. Buy stock and buy an option) Diversification 16
Project appraisal - Steps Promoters Analysis Mgmt. Analysis Technical Evaluation Market Survey & Assessment Feasibility studies Technical & Commercial viability Project Risks & Mitigation Mechanisms SWOT Analysis 17
Project Appraisal Feasibility Study Techno-economic feasibility Analysis of Market and Technology Estimation of project demand potential (Market) Choice of optimal technology (technology) Preparation of a feasibility report Economic viability Identification of market potential Projected market share Size of the project Evaluation of various alternatives Analysis of Cost v/s Benefit of each alternative Selection of the best alternative Pricing schedule Competition 18
Project Appraisal Feasibility Study Financial feasibility Evaluating different measures of commercial profitability Magnitude of finance required and ways to achieve them Financial analysis Return on capital employed, returns on equity, break-even volume and price analysis Robust business assessment Business sensitivity model Cash flow analysis Quality of Management Quality is fitness for use or purpose Joseph M Juran Total Quality Management Management philosophy and company practices that aims to harness the human and material resources of an organization in the most effective way to achieve the organizational objectives. Management Assessment Selection of an appropriate board of directors. 19
Areas of Interest - Stakeholders Stake-Holders Areas Of Interest Promoters Company s existence + Return Shareholders - Preference / Equity Timely payment of Dividends Debt - Secured / Unsecured Repayment - Principal + Interest Employees Timely payment of Salary Suppliers / Vendors / Creditors Timely repayment of Dues Customers Quality Assurance Government Payment of Statutory Dues Society Corporate Governance & CSR 20 November 15, 2011
Role of Debt in Infrastructure Sector Issues Asset liability mismatch due to short term borrowing vs. long term funding. Large volume of resources for capital intensive projects Locking up of funds in specific large projects. High risk involved in Greenfield ventures. Non-uniformity in appraisal, guidelines and documentation requirements. Lack of tangible security and partial or nil recourse basis of funding projects. Risks and Rewards The long term infrastructural projects usually take 15-20 years for completion. The setting-up stage in a project require large funds, which carry higher risk for investors, and thus, financial institutions which provide debt in initial years typically receive a higher rate of interest. In the post set-up phase, the investors have a lower risk as compared to the set-up phase, and thus, receive a lower rate of interest. 21 November 15, 2011
Role of Debt in Infrastructure Sector Mitigation measures - Takeout Finance Scheme Accepted international practice of releasing long-term funds for financing infrastructure projects. Used to effectively address asset-liability mismatch of commercial banks arising out of financing infrastructure projects and also to free up capital for financing new projects. Liabilities of primary lender on project absolved at the end of a specified period Partner institution transfers pertinent loan accounts to its own books, in lieu of an agreed fee or commitment charge. Both parties bear the project risks after the take-out based on a non-recourse structure. Pari-passu charge on the escrow account as security option. Boost the availability of longer tenor debt finance for infrastructure projects. 22 November 15, 2011
Diagrammatic Presentation- Take Out Financing Primary Lender Partner Institution Outstanding Loan Amount (Principal + Interest) 5 years 10 years 23 November 15, 2011 Tenure Of Loan (15 years)
Role of Debt in Infrastructure Sector Mitigation Measures - Sub-ordinate (Mezzanine) Debt Financing Hybrid of debt and equity financing - Finance the expansion of existing companies. Mezzanine financing = Debt capital + Right to lender to convert to equity ownership (if the loan is not paid back in time and in full). Internal restrictions on equity participation by financial institutions, Lower equity and hence limited debt-equity ratio. May result in higher stock value for existing shareholders Repayable after certain years, delaying the obligation to repay the debt. Funding could be considered as deemed equity for a specific period granting the bodies better financial leverage 24 November 15, 2011
Conclusion Forms an important form of finance for transactions. Potential to provide higher returns to the equity shareholders. The cost of borrowing funds also plays an important role in the selection of appropriate capital structure for an entity. 25
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