Project Finance INTRODUCTION Project finance has come of age in India. The promoter/entrepreneur has a wide choice of sources of funds out of which he can choose. The choice, of course, governed by the cost of funds and financial risk. Funds availability should no longer restrict the choice of a project and the technology. The project should be technologically sound, second to none in the world and financially viable. Otherwise the competitive strength would be compromised. Time has come to assess costs and productivity in international terms. The relevance of the project has to be established in international context. A good, sound and viable project would have no problem in finding market acceptance. Project finance is to be financed by borrowing from term lending institutions. Project financing is commonly used as a financing method in capital-intensive industries for projects requiring large investments of funds, such as the construction of power plants, pipelines, transportation systems, mining facilities, industrial facilities and heavy manufacturing plants. The sponsors of such projects frequently are not sufficiently creditworthy to obtain traditional financing or are unwilling to take the risks and assume the debt obligations associated with traditional financings. Project financing permits the risks associated with such projects to be allocated among a number of parties at levels acceptable to each party. Shilpa Bagaria / TYBBI/ Semester V 1
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Project Finance
INTRODUCTION Project finance has come of age in India. The promoter/entrepreneur has
a wide choice of sources of funds out of which he can choose. The choice, of course,
governed by the cost of funds and financial risk. Funds availability should no longer
restrict the choice of a project and the technology. The project should be technologically
sound, second to none in the world and financially viable. Otherwise the competitive
strength would be compromised. Time has come to assess costs and productivity in
international terms. The relevance of the project has to be established in international
context. A good, sound and viable project would have no problem in finding market
acceptance. Project finance is to be financed by borrowing from term lending
institutions.
Project financing is commonly used as a financing method in capital-
intensive industries for projects requiring large investments of funds, such as the
construction of power plants, pipelines, transportation systems, mining facilities,
industrial facilities and heavy manufacturing plants. The sponsors of such projects
frequently are not sufficiently creditworthy to obtain traditional financing or are
unwilling to take the risks and assume the debt obligations associated with traditional
financings. Project financing permits the risks associated with such projects to be
allocated among a number of parties at levels acceptable to each party.
HISTORY
The origins of project finance can be traced to the construction of the
Panama Canal, although the modern origins are the power projects of the 1970s and
1980s where newly created Special Purpose Corporations (SPCs) were created for each
project, with multiple owners and complex schemes distributing insurance, loans,
management, and project operations. Such projects were previously accomplished
through utility or government bond issuances, or other traditional corporate finance
structures.
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The new project finance structures emerged primarily in response to the
opportunity presented by long term power purchase contracts available from utilities
and government entities. These long term revenue streams were required by rules
implementing PURPA, the Public Utilities Regulatory Policies Act of 1978.
Originally envisioned as an energy initiative designed to encourage domestic renewable
resources and conservation, the Act and the industry it created lead to further
deregulation of electric generation and, significantly, international privatization
following amendments to the Public Utilities Holding Company Act in 1994.
WHAT IS PROJECT FINANCING? "Project financing is financing the development or exploitation of a right,
natural resource or other asset where the bulk of the financing is not to be provided by
any form of share capital and is to be repaid principally out of revenues produced by the
project in question".
The essence of project lending is therefore its focus on the project being
financed. The project lender looks, wholly or mainly, to the project as the source of
repayment; its cash flows, and assets where appropriate, are dedicated to service the
project loan. The project cannot even begin to provide for repayment until it is
operational, and then depends on continued sound operation, so its analysis is critical.
Key elements of project financing- The financing of the project is made available and the money is invested before the
construction of the infrastructure is completed.
- The project lenders have no "recourse" outside the specific project (or only "limited
recourse"). This means that the project lenders limit their recourse to the project
company's assets and revenues in case the project company is unable to repay its debts.
Therefore, there are no guarantees of the project company's obligations to repay loans
Technical Aspects → 1. Planning, Scheduling 2. Setting of Priorities 3. Task Identification 4. Logistics 5. Equipment Use and Schedules
Personnel → 1. Organization and Staffing 2. Leading and Motivating 3. Communication 4. Resolution of Conflicts 5. Negotiation 6. Performance Evaluation
Administration → 1. Estimating and Controlling Cost 2. Budgeting 3. Cash Flow Monitoring 4. Management Information System 5. Systems and Procedures 6. Terminal Project Evaluation
External Relations → 1. Relation with Financial Institutions 2. Contracting and Use of Consultants 3. Dealing with Suppliers and Sub- Contractors 4. Coordination with Other Agencies
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Operating Procedures for Getting Working Capital
The working capital is the amount of funds which a unit needs to finance
its day-to-day operations and in this sense it can be regarded as that part of the total capital
which is employed in the short-term operations. The constituents of the working capital are
stocks of raw materials and suppliers, work-in-progress, finished goods, book debts and the
minimal cash, and bank balances. The working capital needs of the unit are essentially to
be met by borrowings from the commercial banks. Till recently there were no standards or
guidelines for setting out the precise amount of gross or net working capital needed by
various enterprises. Recently however, a particular study group which looked at the
question suggested the guidelines with a view to: (1) make customer plan his credit needs
in advance and observe discipline in its use; (2) indicate to the banker the likely demand for
credit and thus enable him to plan his own deposit-credit function; (3) assure finance to
industry for its genuine production needs; (4) having provided finance, enable the banker to
receive from the customer adequate flow of information on the use of credit, but within-
built flexibility to suit changes in circumstances. As per the guidelines of the committee,
the commercial banks have to understand and interpret the extent of working capital gap in
borrowers business at any given time and decide the appropriate method of arriving at the
maximum permissible level of bank credit to the borrower. The study group presented three
alternatives, which can also be considered at three sequential stages, for deciding the
maximum permissible bank finance:
Method I : Determine the working capital gap, i.e. a reasonable level of total current
assets minus non-bank current liabilities and reckon 75 percent of the working capital gap
as the permissible level of bank finance. The balance has to be found by the borrower from
his own funds and/or from long-term borrowings.
Method II: The borrower will have to get his own resources and/or long-term funds to
finance 25 percent of the total current assets. Whatever is then required to meet the
working capital gap will be provided by the banker.
Method III : Determine the core current assets. These have to be financed out of own
fund and/or long-term borrowings. The reasonable level of total current assets less core
current assets will represent “real current assets”. Twenty-five percent of real current assets
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will also have to be supported by the borrowers own funds and/or long-term borrowings. If
the non-bank current liabilities are inadequate to cover the balance 75 percent of the real
current assets, the required amount will be obtained by way of bank borrowings.
Problems in the Operation of a Unit
After completion of the pre-operation phase, the unit became operational.
Some of the problems can be traced back to faulty project formulation; others arise
because of internal working of the project or change in the external environment.
1] Faulty Project Formulation and Implementation
Faulty project formulation and handling in the pre-operation phase leads
to problems in the operation phase of the project. Faulty project formulation can often
be traced back to faulty product selection, doubtful financial viability and wrong
location which would lead to problems in using the installed capacity. The problems
caused by faulty project formulation and implementation often require additional
finance and nursing of the units.
2] Non-availability of Raw Materials
Incase of industrial projects, raw materials constitutes a very
substantial portion of the cost of production. Therefore, any problem in procuring raw
materials at a reasonable price leads to a situation of under utilization of capacity,
higher breakeven capacity, and lower profitability unless the output prices can also be
changed accordingly. Again the output prices of many industries are under government
regulation and control which makes it difficult to look after the output prices in
proportion to cost escalation.
Raw material problem may also arise because of a change in
government policy with respect to imports of those materials. Apart from raw materials,
power cuts and lack of other utilities also cause problems in utilization of installed
capacity. If an industry uses continuous process, much time is lost in putting the
process back into operation after the power cut.
3] Poor Financial Management
Problems arising out of poor financial management can be usually
traced to low equity base, false investment decisions, working capital difficulties, loose
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accounting, costing and record keeping. Although the debt-equity ratio and the
promoter’s contribution requirements have been considerably liberalized, in practice
entrepreneurs need higher equity base to at last tide over unforeseen cost escalations. In
the absence of such a base, even managerial cost escalations create problems for
functioning of the unit. It has also been observed, particularly in the case of industrial
units, that the working capital requirements are not anticipated and forecasted well.
Therefore, commercial banks grant the working capital limits which are not sufficient
to take care of various production and marketing requirements. When the unit begins to
face the constraint of working capital, production suffers. Bankers became reluctant to
grant additional limits. The unit then gets into the vicious circle.
Lack of project accounting, costing, and record keeping makes
the cost control and pricing decisions difficult, leading to financial problems. This is
observed more so in the case of several industrial units where there are no qualified
accountants. Once the problems crop up, banks begin to ask for various kinds of data
which is difficult for these units because the data simply do not exist in that form.
Problems of Industrial Relations and Operating Style
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Industrial parce and workers co-operation are key factors in
realizing production build-up as anticipated. Units get into difficulty in early stages
because of labour problems. Some of the labour problems can be traced to the operating
styles of the entrepreneur and lack of managerial effectiveness. Sometimes promoters
themselves do not operate as a cohesive group. There are cases where doubleful
integrity and entrepreneurial commitment to project on the part of promoters cause
problems for operating the unit profitably
1. Marketing Problems
Many small scale and industrial units face problems in marketing
their products. Some of these problems can be traced back to inadequate market
analysis at the project formulation stage. Other marketing problems arise because of
inappropriate marketing strategy and or low-key market development effort. Some of
the industrial products require longer gestation periods than initially expected in
developing the tastes and clientele.
2. Environmental Problems
These are problems that arise from changes in external environment
faced by the unit. These changes arise because of changes in government policies
and/or critical shortages of raw material and utilities. For example, time to time serious
shortages of coal and power cuts cause problems for production. Ban on movement of
final product also creates problems in realizing the remunerative prices and, therefore,
problems of capacity get aggravated.
3. Technical Production Problems
Very often, particularly in the case of indigenously developed
technology, problems arise in the process of expanding pilot plants to commercial scale
units. The know-how is not fully technically foolproof. In case of the imported know-
how also, shortage of spares and critical equipment break-downs causes production
break-down. Without appropriate production build-up, a whole host of problems
discussed above arise. Sometimes the technical production problems can be traced to
the improper scheduling and monitoring of production. This aspect can also be linked
with lack of managerial effectiveness.
Types of Ratios
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1. Pay back Period (P): The pay back period is defined as the time period within
which the initial investment on the project is recovered by the unit in the form of revenues.
To put it differently this is the length of time between the initial investment on the project
and the time when this initial investment is completely recovered from the net yearly
revenues. In symbolic terms if the net yearly cash flows are same every year, we can
express the pay back period as follows:
P= I CWhere P is pay back period
I is the initial investment and
C is the yearly net cash inflow.
2. Net Present Value (NPV): The net present value of investment is calculated by
taking a discounted sum of the stream of net income during the expected life of the project
It is necessary to discount the future stream of net income because costs and returns in
different time periods are not strictly comparable. In symbolic terms we can express the
NPV of a project generating net cash flows of R1, R2, R3, …., Rn for n years as follows:
NPV = R 1 + R 2 + … + R n - I (1+ r) (1+ r) ² (1+ r) ⁿ
where 100 r percent is the discount rate. The investment is considered sound if the NPV is
positive. A negative NPV indicates that the project is not worth considering at a given
discount rate.
3. Internal Rate of Return (IRR): The internal rate of return is that rate of return
which makes the net present value equal to zero. Thus, it is the discount rate which makes
the initial investment in the project equal to the discounted net returns from the investment
during the entire life of the project, In symbolic terms we can express it as:
n Rt - I = 0
∑ (1 + r) t t = 0where Rt are the net returns in each of the n years and (1 + r)t is the discount factor. In this
case R is to be estimated such that the discounted net returns from the project equal zero.
The estimated value of R is then compared with the cost of capital. If the internal rate of
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return (IRR) is higher or equal to the minimum desired yield or rate of return, then we
accept the project proposal. Otherwise, the project is rejected and as a corollary to this
between the two projects if one yields higher IRR than the other, the first one is preferred
to the second.
To enable the entrepreneurs to form a judgment about the efficiency of the
enterprise, creditworthiness, and his return on key aggregates, some financial ratios can be
computed from the projected financial statements of the unit.
4. Efficiency Ratios: As the name indicates these ratios provide information on the
efficiency of the proposed industrial unit. Some of the important ratios in this regard
include inventory include turn-over and operating ratios.
5. Inventory Turnover Ratio: The inventory turnover is computed as follows: sales
are divided by the inventory. This ratio measures the number of times the unit turns over its
stock each year and indicates the stock of inventories required to stock a given level of
sales. It is generally observed that in agro-processing industries this ratio is lower
compared to other industries because of their seasonal operations. It is also observed that
industrial units have to generally keep several months of inventories to support their
processing operations and production schedules. A lower ratio also implies that sizable
amount of funds are locked up in inventory for long times. It is to be judged whether the
computed ratio is reasonable, given the conditions and practices prevailing generally in that
industry.
6. The Operating Ratio: This ratio is computed by dividing the operating expenses
with the revenue. This ration indicates the ability of the unit to control operating costs
including overhead expenses. This ratio is generally used in comparing the performance
over the time of the same unit or comparing the performance of he proposed unit with that
of other units. If it is observed from the projected statements that the ration increased over
time, it implies either the cost of raw materials is increasing or the labour cost is increasing
or there are wastages in the production process and/or there is substantial competition
necessitating a reduction in prices. When the operating ratio becomes very high the unit
may have difficulty in making an adequate return. On the other hand, if this ratio is very
low, one has to examine whether some of the cost items have been omitted.
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7. Income Ratio: An entrepreneur has to examine whether the projected enterprise
would be able to provide or generate resources for reinvestment and growth and its ability
to provide a reasonable return on investment. The most important income ratios are:
(1) Return on sales, (2) Return on equity, and (3) Return on assets. These income ratios
vary from year to year. Therefore these need to be computed for each year from the
projected statements for the unit.
(A) Return on sales: This ration indicates the operating margin of the unit on its sales.
If the return on sales or the operating margin is low it implies that the unit will have to have
a large volume of sales in order to earn an adequate return on investment. This ratio is
usually used for comparison purposes with the units in the same industry or the same unit
over time. Since the acceptable level of the ratio varies from industry to industry it is
meaningless to compare this ratio across industries.
(B) Return on Equity: This ratio is computed by dividing the net income after tax by
equity. This ratio helps the entrepreneurs to compare various investment opportunities and
select the project proposal which yields a satisfactory return on investment.
(C) Return on assets: This ratio indicates the earning power of the assets of the
proposed unit and it is computed by dividing the operating income by the value of assets. If
the proposal is to be acceptable for entrepreneurs, the return on assets should exceed the
cost of capital; otherwise the project is not viable from the point of view of the
entrepreneurs in the sense this ratio is close to the calculations or indicators of the financial
viability in the previous section.
8. The Creditworthiness ratio: These ratios indicate the degree of financial risk
inherent in the enterprises before going for them. These ratios also indicate the type of
financing and term the proposed unit would require so that it may be able to survive even
the adverse circumstances. Some of the important ratios in this category are the current
ratio, the debt-equity ratio, and the debt-service coverage ratio.
9. The Current Ratio: This ratio is computed by dividing the current assets by the
current liabilities. This is an important ratio for the lending agencies to assess the enterprise
in terms of the margin that the proposed unit has for its current assets to shrink in value
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before the unit gets into difficulty in meeting its current obligations. The appropriate level
of this ratio depends on the type of industry and trade practices in in the industry where the
proposed unit would belong. For example, if the unit has a large inventory turnover and if it
can collect its accounts receivables promptly, then the current ratio can be lowered. If the
current ratio is very low then, the unit has to exist on a day-to-day basis which may led to
uneconomic practices because it is possible that its output may have to be sold at lower
prices for cash, or it may be able to carry sufficient inventory to meet the production
schedules, or it may have to buy inventories in small lots and, therefore, pay higher prices
for the inventories, etc. Once again, the appropriate level of this ratio for the proposed unit
will have to be judged in the light of other ratios as indicated.
10. Debt-equity Ratio: This ratio is computed by dividing the long-term liabilities by
the sum of long-term liabilities plus equity to obtain the proportion that long-term liabilities
are to total debt and equity, and then by dividing equity by the sum of long-term liabilities
plus equity to obtain the proportion that equity is to the total debt and equity.
11. The Debt Service Coverage Ratio: This ratio can be computed on a before-tax
basis or after-tax basis. If the debt service coverage ratio is computed on a before-tax basis,
it implies that the funds from operations have been divided by interest plus repayment of
long-term loans. If the calculations are done on after-tax basis, it implies that the taxation
expenses have also been taken out and, therefore, it is even sounder. This ratio is computed
as the net income plus depreciation less interest paid divided by interest paid plus the
payment of long-term loans.
It is again very difficult to ascribe any rule of thumb for the debt-service
coverage ratio. This ratio has been interpreted along with the analysis of sources and uses
of funds for the unit and the pool of funds remaining after all requirements for maintenance
and improvements of current operations and orderly expansion. If the ratio decreases over
time, it may be due to the over-ambitious expansion programmed or change in credit terms
which have lengthened the repayment period, etc.
APPRAISALS IN PROJECT FINANCE
1. TECHNICAL APPRAISAL
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A] Appraisal of project
At the outset it may be clarified that the terms evaluation, appraisal and
assessment are used interchangeably. They are used in analyzing the soundness of
an investment project, i.e., in an ex ante analysis of the effects of implementing a
project. The analysis is based on projections in terms of cash flows. The analysis is
carried out by the entrepreneur or promoters of the project, the merchant banker
who is going to be involved in the management and underwriting of public issue
and financial institutions who may lend money.
Evaluation of industrial projects is undertaken to compare and evaluate
alternative opportunities in terms of projects exist for commitment of resources.
Project selection can only be rational if it is superior to others in terms of
commercial profitability i.e. net financial benefits accruing to owners of the project
or on national profitability i.e. net overall importance of the project to the nation as
a whole. The purpose of the project appraisal is to ensure that the project is
technically sound, provides reasonable financial return and conforms to the overall
economic policy of the country.
B] Objectives
Technical appraisal is primarily concerned with the project concept
covering technology, design, scope and content of the plant as well as inputs and
infrastructure facilities envisaged for the project. Basically, the project should be
able to deliver marketable product from the resources deployed, at the cost which
would leave a margin adequate to service the investment and plough-back a
reasonable amount to enable the enterprise to consolidate its position. Technical
appraisal has a bearing on the financial viability of the project as reflected by its
ability to earn satisfactory return on the investment made and to service equity and
debt.
C] Project Concept
Project concept comprises various important aspects such as plant
capacity, degree of integration, facilities for by-product recovery and flexibility of
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the plant. Accurate assessment of plant capacity on a sustained basis is of crucial
importance.
D] Capacity of the Plant
Capacity of a plant depends on several factors such as product
specification, product mix and raw material composition. It is indeed difficult to
assess capacity. In a textile mill, capacity varies with the composition of yarn of
different counts. The additional investment would improve the profitability
enormously.
E] Flexibility of Plant and Flexible Manufacturing Systems
While assessing a project, flexibility of the plant should be allowed in the
design of individual pieces of equipment. Flexible manufacturing systems are the
emerging systems to manufacture what the customer wants. These systems help in
the production of a large variety of products.
F] Evaluation of Technology
Outstanding features of technology process, engineering design and plant
and machinery are established facts and can be checked from published information
on the process or from prospective collaborators/consultants and on the basis of
similar plants in operation elsewhere. However, considerable skill is required in
evaluating the claims of emergent technology, products and equipment design.
The design and layout of the plant in technical appraisal should ensure
ease of operation and convenience of maintenance and uncomplicated expansion of
the stream capacity, should the need arise.
Above all, in technical appraisal one should be alert and apply trained and
informed skills. For example, the availability of soft water is essential for a textile
processing plant. It is on record that a public sector textile processing plant was set
up without checking the quality of water. The result was a large additional
investment to cure water.
G] Inputs
In technical appraisal, inputs are scrutinized for availability and quality
dependability. If there are seasonable variations, especially, in the case of
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agricultural inputs, variations in price have to be checked. Similarly power quality
has to be checked in terms of variation in supply voltage and in-line current
frequency and duration of black-outs.
H] Location
While it is easy to enumerate desirable factors to be taken into account
while determining location, in practice various constraints dictate location away
from the ideal one. The ideal factors are of course, proximity to the market and
inputs, preferably where well developed infrastructure exists. In some industries
effluent disposal facility is necessary. Pollution control restricts the use of steam
boilers while power scarcity restricts the installation of induction furnaces which
are environment friendly. Antipollution regulations may also force the choice of
large size plants to curtail noise pollution or to install anti-vibration equipment with
adverse impact on costs.
I] Interdependence and Parameters of Project
Finally, the technical appraisal of the individual project may be
supplemented by a supplementary review of the project in terms of interdependence
of the basic parameters of the project which are, plant size, location and technology.
A small integrated paper plant using bagasse, paddy husk or straw without need to
recover process chemicals may be more viable than large integrated paper mill
requiring forest based raw material, water and effluent disposal system. Sometimes
undependable supply of basic inputs could spell disaster.
The implementation of the project has cost and time over-run implications.
The scheduling of construction and the identification of potential causes of delay
form an important part of the technical aspects of the project appraisal. The
schedule of construction depends mainly on the speed of civil construction works,
delivery period of equipment, as well as the efficiency of the management to tie-up
various ends in a coordinated and speedy manner. Since an over run in the pre-
commissioning time invariably leads to over run in cost and consequential
problems, it is important that timing of construction is realistically planned. For all
main physical elements of the projects, from project concept, obtaining Government
approvals, tying-up financial arrangements, engineering design, land acquisition,
building construction, procurement of equipment, its erection and testing to final
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commissioning, there must be realistic time schedules and a coherent arrangement,
which leads to the completion of the project on most economical basis.
J] Project Charts and Layouts
Project charts and layouts have to be prepared to define the scope of the
project and provide the basis for detailed project engineering. These are general
functional layout, material flow diagram, production line diagram, utility layout and
plant layout.
General functional layout should facilitate smooth and economical
movement of raw materials, work-in-process and finished goods. Material flow
diagram presents flow of materials, utilities, intermediate products, final products,
scrap and emissions. Production line diagram establishes the progress of production
from one machine to another with description, location, space required, need for
power and utilities and distance from the next section. Utility layout shows the
principal consumption points of power, water and compressed air which help in the
installation of utility supply. Finally, plant layout identifies the exact location of
each piece of equipment determined by proper utilization of space leaving scope for
expansion, smooth flow of goods to minimize production cost and safety of
workers.
K] Cost of Production
Estimates of production costs and projection of profitability is the
concluding part of the technical appraisal. Cost of production is worked out taking
into account the build up of capacity utilization, consumption norms for various
inputs and yields and recovery of by-products. In estimating production, a general
build-up starting with 40 percent and reaching a normal level of 80 percent in three
to four years time is provided. In practice capacity utilization may fall short of
estimated levels on account of defective plant and machinery, inadequate operating
skills, inadequacy of raw materials, shortage of power and lack of demand. The cost
of production and profitability estimates take into account the level of production in
different years and product mix, norms of raw material consumption, power and
fuel requirement, their costs, salaries and wages, repairs and maintenance,
administrative overheads, selling expenses and interest on borrowings. Adequate
provision is made for higher expenses in the initial years for technical troubles,
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higher wastages and lower yields, lower operating efficiency and higher selling
costs. Here, too, comparison with similar projects is useful. The profitability
estimates should be on a realistic selling price. In a competitive market, penetration
price for a new producer will have to be lower than the current price of an
established manufacturer
2. MARKET APPRAISAL
a. Introduction Analysis of demand for the product proposed to be manufactured requires
collection of data and preparation of estimates. Market appraisal requires a description of
the product, its major uses, scope of the market, possible competition from substitutes,
special features of the product proposed to be manufactured in regard to quality and price
which would result in consumer preference for the product in relation to competitive
products. Estimates have to be made about existing and future demand and supply of the
products proposed to be manufactured. An assessment of likely competition in future and
special features of the project which may enable it to meet competition has to be made.
Export possibilities have to be identified and comparative data on manufacturing costs have
to be compiled. It is necessary to identify principal customers and state particulars of any
firm arrangements entered into with them. Selling arrangements contemplated in terms of
direct sales or through distributors or dealers have to be classified.
After collection of data, the existing position has to be assessed to ascertain
whether unsatisfied demand exists. Since cash flow projections are to be made possible
future changes in the volume and the pattern of supply and demand have to be estimated.
This would help in assessing the long term prospects of the unit.
Estimation of demand requires the determination of the total demand fr the
product and the share that can be captured by the unit through appropriate marketing
strategies. The commonly used methods of demand forecasting are trend, regression and
end-use methods.
b. Trend Method The trend method assumes that the behavior of the variable would continue in
the same direction and magnitude as in the past. In this method, it is useful first to draw a
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graph to ascertain whether a linear or an exponential trend is appropriate for projection.
The assumption under linear trend is that the variable would increase by a constant amount,
whereas in exponential it will change by a constant percentage amount. Graphing the data
will help to decide which period to choose and what type of form be used for forecasting.
Only after analysis of past data the trend line should be fitted.
c. Regression Approach In regression approach the factors influencing the variables that are to be
forecast have to be identified. In this method we have the dependent variable and the
explanatory or independent variable. The dependent variable is the one subject to
forecasting. The explanatory variables are those which cause changes in the dependent
variable. If the rate of inflation is to be forecast, the independent variables may be money
supply, per capita availability of food grains and rate of monetization of the economy.
Specification or identification of factors is crucial in forecasting by regression approach. In
multiple regressions we have more than one explanatory variable.
The regression coefficients should have the right sign and be statistically
significant. The actual value of dependent variable and the estimated value should be close
to each other for the sample period.
d. End-Use Method In this method the users of the product, proposed to be manufactured, are
identified. An intensive study of the past and present situation and a through assessment of
the future prospects of the various end user industries. A study of the consumption norms
for each end user industry in respect of the product for which forecasts are needed is also
made. However, provision should be made for changes in the norms as a result of
technological change or emergence of substitute products.
The end use approach enables customer industry wise demand forecasts and it
is easy to evaluate any discrepancy in the forecasts with the actual value. The method is
appropriate for intermediate industrial products such as steel and caustic soda.
Demand projections and estimates are made by agencies of government as
well as industry associations. Among the government agencies, the Directorate General of
Technical Development and the Planning Commission may be mentioned. Several
Associations of manufacturers make estimates. In regard to small scale sector, the
Development Commissioner for Small Scale Industries, the National Small Industries
Corporation and the Small Industries Services Institute provide valuable market
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information about projects and products. Several private consultants undertake market
surveys for the fee
The key elements of market appraisal, both informal as well as formal, are
plans, and (4) assessment of market potential and demand forecasting. These key elements
are discussed in detail in subsequent paragraphs.
3. FINANCIAL APPRAISAL
a. Introduction Financial appraisal is concerned with assessing the feasibility of a new
proposal for investment for setting up a new project or expansion of existing productive
facilities. This involves an assessment of funds required to implement the project and the
sources of the same. The other aspect of financial appraisal relates to estimation of
operating costs and revenues, prospective liquidity and financial returns in the operating
phase. In appraising a project, the project’s direct benefits and costs are estimated at the
prevailing market prices. This analysis is used to appraise the viability of a project as well
as to rank projects on the basis of their profitability. It may be noted that financial appraisal
is concerned with the measurement of profitability of resources invested in the project
without reference to their source.
For the purpose of appraisal it is necessary to make estimates relating to
working results in case of existing concerns, cost of the project and the means of financing.
Financial projections for a ten year period have also to be made.
b. Working Results of Existing Units In the case of an existing unit, it is desirable to make an assessment of its
latest financial position. For this purpose, its latest audited balance sheet and profit and loss
statement as well as the balance sheets for the last five years have to be analyzed. In case
an audited balance sheet as on a fairly recent date is not available, a proforma balance sheet
and profit and loss statement certified by the management may be examined
The latest balance sheet and profit and profit and loss account may be
analyzed with a view to ascertaining, whether the concern is under/over capitalized,
whether the borrowings raised are not out of proportion to its paid up capital and reserves,
how the current liabilities stand in relation to current assets, whether the gross block has
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been properly depreciated and has not been shown at an inflated value, whether there is any
inter-locking of funds with associate companies and whither the concern has been
ploughing back profits into the business and building up reserves.
c. Cost of the Project The capital cost of the project whether it pertains to expansion or a new
project should be shown under,
(a) land and site developments,
(b) buildings,
(c) plant and machinery,
(d) technical know-how fees,
(e) expenses on foreign technicians and training of Indian technicians abroad,
(f) miscellaneous fixed assets,
(g) preliminary and pre-operative expenses,
(h) provision for contingencies and
(i) margin money for working capital.
It has to be ensured that all these items are covered in the cost and the
expenditure under each item is reasonable. As a part of the process of an appraisal of the
capital cost of the project, it is desirable to compare the cost of the project with the cost of
the similar project or by the information about cost that may be gathered in respect of other
units in the same industry with comparable installed capacity and other common technical
features.
d. Sources of Finance The usual sources of finance for a project are:
Equity capital, term loan, deferred payment, unsecured loans from promoters and internal
accruals in the case of an existing unit.
A balance has to be struck between debt and equity. A debt equity ratio of 1:1
is considered ideal but it is relaxed up to 2:1 in suitable cases. Further relaxation in debt
equity is made in the case of capital intensive projects. All long term loans/deferred credit
are treated as debt while equity includes free reserves. Equity is arrived after deducting
carried forward losses in the case of an existing unit.
The norm for promoter’s contribution in the project is 22.5 percent of project
cost with a lower contribution for projects promoted by technical entrepreneurs. Normally
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the promoter’s contribution should be brought in by way of equity capital. If unsecured
loans from promoters/directors form an integral part of the means of finance, it should be
assumed that they would not be withdrawn during the currency of the loan and do not carry
interest higher than that payable on institutional loans. Preliminary expenses incurred by
the promoter are included in promoter’s contribution.
It is important that no gap is left in financing patterns. Otherwise it will result
in delays in implementation of the project. A condition is stipulated by financial institutions
that the promoters shall arrange for funds to meet any over run in the cost of the project.
While the emphasis of the financial institution is on the viability of the project they
generally stipulate by way of security, a first legal charge on fixed assets of the company
ranking pari passu with the charge if any, in favour of other financing institutions.
e. Financial Projections For the purpose of determining the profitability of the project and the ability
of the company to service its loans and give a reasonable return on the equity capital,
estimates of cost of the project, profitability, cash flow and projected balance sheets have to
be prepared in the proforma given for ten years. These are inter related and are prepared on
the basis of the estimated cost of the project, sources of finance envisaged and various
assumptions regarding capacity utilization, availability of inputs and their price trends and
selling price. The important assumption that should be scrutinized carefully before making
estimates are capacity build up, raw material cost, estimate of wages and salaries, cost of
utilities, estimate of administrative expense, selling price assumed and provisions made for
depreciation and statutory taxes. Verification of profitability is the core of proper appraisal
of the project. The entrepreneur may be naturally tempted to present a bright picture but it
is the task of financial appraisal to verify the estimates. It is to be ensured that the profits
projected are realistic. In case of new units, any sharp build up of capacity within a year or
two will be unwarranted especially if the product is new. The quantum of raw materials and
utilities estimated to be consumed to obtain a particular quality/quantum of end product is
the core of cost of manufacture estimates and should tally with the performance guarantees
furnished by the collaborators/machinery suppliers. In case of multi product firms, the
product mix is decided on the basis of contribution of each product, utilization of plant
capacity as well as market. Annual increases in wages and salaries should be about 5
percent.
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Repairs and maintenance will have to be provided keeping in view the type of
industry and the number of shifts to be worked. Depreciation of the fixed assets should be
provided as per income tax rules. The selling price should be fixed keeping in view the
present domestic price of the product. The profitability projections are closely linked to the
schedule of implementation. On the basis of profitability projections, cash flow and
projected balance sheets are prepared for a period of ten years.
f. Evaluation of Cash Flow and Profitability Financial appraisal uses two popular methods and two discounted cash flow
techniques to evaluate the cash flows and profitability of investment. The methods should
have three properties to lead to consistently correct decisions. First, it should consider all
cash flows over the entire life of a project; secondly, it should take into account the time
value of money and finally it should help to choose a project from among mutually
exclusive projects which maximize the value of the firm’s stock.
4. ECONOMIC APPRAISAL
Aspects of Economic Appraisal Economic appraisal of a project deals with the impact of the project on
economic aggregates. We may classify these under two broad categories. The first deals
with the effect of the project on employment and foreign exchange and second deals with
the impact of the project on net social benefits or welfare.
a. Employment Effect While assessing the impact of a project on employment, the impact on
unskilled and skilled labour has to be taken into account. Not only direct employment, but
also indirect employment should be considered. Direct employment refers to the new
employment opportunities created within the project and the first round of indirect
employment concerns job opportunities created in projects related on input and output sides
of the project under appraisal.
b. Net Foreign Exchange Effect A project may be export oriented or reduce reliance on imports. In such cases
an analysis of the effects of the project on balance of payments and import substitution is
necessary. The assessment of project on the country’s foreign exchange is done in two
stages; first, balance of payments effects of the project and second, import substitution
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effect of a project. The import substitution effect of a project measures the estimated
savings in foreign exchange owing to the curtailment of imports of the items of production
of which has been taken up by the project.
The analysis of net foreign exchange effect may be done for the entire life of
the project or on the basis of a normal year. If two or more projects are compared on the
basis of their net foreign exchange effect, the annual figure should be discounted to their
present value.
c. Social Cost Benefit Analysis
1. Objectives Another aspect of economic appraisal is social cost benefit analysis. Cost
benefit analysis is concerned with the examination of a project from the view point of
maximization of net social benefit. While cost benefit analysis originated to evaluate public
investment, it is also used in project appraisal. Earlier, project appraisal covered only
private costs and benefits, at present, social costs and benefits are also reckoned.
Cost benefit appraisal of a project proposes to describe and quantify the
social advantages and disadvantages of a policy in terms of a common monetary unit. An
enterprise or project adopting cost benefit analysis approach has, as its objective function,
net benefits to society whereas the objective function of a private project is net private
benefit or profit. Net social benefit entails that gains and losses be valued in a common
unit. The unit should reflect society’s strength of preference for each outcome. The
economist uses as a measure of this preference, the consumer’s willingness to pay (WTP)
for a good. This will be reflected in the price he pays, though not fully.
In many cases the prices are not observable or are distorted. In these
circumstances cost benefit analysis must seek surrogate prices or shadow prices to measure
what would the society be willing to pay if there is a market? Net social benefits are found
by deducting from benefits (WTP) compensation required (cost). Maximization of net
benefit should be finally equivalent to the maximization of social utility or social welfare.
Social costs and benefits and private costs and benefits differ because of market
imperfections, externalities and income distribution
2. Market Imperfections Private costs and profits reflect social costs and benefits only under perfect
competition. Since markets were largely regulated and prices were administered earlier in
our country, resources used by private sector were under priced. The recent phenomenon of
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deregulation which has freed several resource prices from control may lead in future to
near approximation of conditions in perfect competition. For instance, foreign exchange
rate is now determined by markets. Since 1991, the interest on debentures is not fixed by
government. In several markets regulation and administered prices are being lifted.
3. Externalities The difference between private costs and benefits and social costs and
benefits arises mainly because of externalities. The divergence arises because of economic
effects a transaction has on third parties. The effects may be benefits or costs. A project, for
instance, when it creates infrastructural facilities like roads, the area adjacent may be
benefited. Such benefits are, however, not included in assessing the benefits arising out of
the project. Actually, such benefits are invariably under provided and subsidies may have
to be paid to ensure their provision. On the other hand, a project may have harmful
environmental effects. Such costs are not internalized and not paid for by consumers or
producer. As a result, costs are imposed on society which is not accounted for. The activity
in question may also be over-extended.
The problem of externalities relating to environmental effects received
impetus from the thesis propounded by World Bank that wise environmental policies may
often make poor countries less poor. Not only is sound environmental policy essential for
durable development but many of the policies that improve the environment will also
strengthen development. They are also powerfully re-distributive since it is often the poor
that suffer from environmental degradation.
The cure for poverty is development. Development may also cure some kinds
of pollution. Given the right technologies, developing countries can decouple some kinds
of pollution from economic growth with beneficial effects on the economy.
4. Redistribution Strictly from the viewpoint of the project promoter or owner, it is of no
consequence as to how the projects benefits are distributed among society. But to society or
government, it is essential to have information as to who benefits from the investment in
various projects. For instance, industrial projects are put forward and promoted whether in
private or public sector to alleviate poverty and improve income distribution. Our entire
five year plan has poverty alleviation as their basic objective. It is however, not appreciated
that the provision opportunities through industrial projects cannot be availed of by the poor.
The poor are unskilled and illiterate and do not have the skills that factory type of
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employment demands. To benefit poor, the emphasis should be on provision of
opportunities through Grih Udyog or rural cooperatives and on repetitive tasks which
demand little skill, such as textile printing, assembly and agro-material processing. The
structure of investment should not be to elongate the productive process or make it indirect.
Our plans have not been able to relieve poverty because projects promoted are of the
factory type. They are not suitable for integrating poor into market oriented activity.
Social cost benefit analysis is a specialized subject.
Sources of Term Loans: Development Finance Institutions
1. Industrial Development Bank of India (IDBI)
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The Industrial Development Bank of India (IDBI) which was established in
July 1964 under and Act of Parliament is the principal financial institution for providing
credit and other facilities for development of industry. It also promotes or develops
industrial units, coordinates working of institutions engaged in financing, and assisting
development of such institutions. IDBI has been providing direct financial assistance to
large and medium industrial units and also helping small and medium industrial concerns
through banks and state level financial institutions. The IDBI 1964 provides for the
following functions to be performed by it:
(1) Coordinate the activities of the other financial institutions including
Commercial banks
(2) Supplement their resources by providing refinance to these institutions
(3) Plan and promote industries of key significance to the industrial structure
(4) Adopt and enforce a system of priorities in promoting further industrial
growth.
The activities of the IDBI related to provision of finance may be broadly divided into five
groups: (1) direct assistance to industrial concerns in the form of loans, underwriting, and
subscription to shares and debentures and guarantees; (2) refinancing of industrial loans
granted by banks and other financial institutions; (3) rediscounting of bills arising out of
sales of indigenous machinery on deferred payment basis; (4) finance for exports in the
form of direct loans and guarantees and buyers abroad in participation with commercial
banks and refinancing of medium term export credit granted by commercial banks; and
(5) assistance to other financial institutions by way of subscription to their shares and
bonds.
2. Industrial Credit and Investment Corporation of India
(ICICI) Industrial Credit and Investment Corporation of India (ICICI) was established
on January 5, 1955, and commenced its operations on April 14, 1955. The main objective
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of ICICI was to encourage and assist industrial investment in the private sector. Under its
Memorandum of Association, the ICICI was to accomplish its main objective by providing
medium and long-term loans in rupees and foreign currency, investment in equities,
underwriting shares and debentures issues, guaranteeing loans from other private sources,
and by providing managerial and technical assistance to enterprises. The main purpose for
which ICICI assistance is available is for the purchase of capital assets in the form of land,
building, and machinery. The ICICI also assists in planning and execution of an investment
proposal even from the very early stage.
The ICICI does not quote standard terms for loans and other financial assistance. Each case
is considered on its merit and decisions are made in the light of the risks involved, the
prevailing condition and practices of financial institutions, and the cost of ICICI’s own
funds. According to the resources position, the composition of assistance has varied from
year to year. The forign currency loans constitute the major form assistance. In respect of
loans, a commitment charge at a marginal rate is levied on the undrawn portion of the loan.
Full interest accrues on the portions of the loan disbursed. Loans are granted for periods up
to 15 years.The rates of ICICI’s underwriting commission are notified in the letter of
underwriting.
Since ICICI provides a major portion of its assistance in the form of foreign
currency loans, the pattern of assistance displays weight age in favour of industries which
require greater foreign currency credit. Some of the major industries which have received
assistance from the ICICI are chemical and petro-chemical industry, fertilizers, metal and
metal products, machinery manufacturing, and electrical equipments.
Operating Aspects and Policies of Financial Institutions The development banks and other term lending institutions have o perform
appraisal tasks before deciding whether the project is bankable and whether the required
finances can be sanctioned. The appraisal tasks basically include the verification of
assumptions relating to technology, market, organizational structure, financial viability, and
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economic viability. More specifically the activities in the appraisal process can be
described as follows: (1) technical analysis, to determine whether the specification of
technical parameters is realistic and optimal.
(2) Commercial analysis, to determine whether product specification and
marketing plan and organizational structure are soundly conceived.
(3) Financial analysis, to determine whether financial costs and returns are
properly estimated and whether the project is financially viable.
(4) Social profitability analysis, to determine whether a project is worthwhile
from the point of view of society.
Procedures for Sanctioning Financial Assistance The basic inputs for the appraisal process are derived from the feasibility
report as well as the information supplied by the entrepreneur in the application form for
financial assistance. Thus, the formal process of getting the assistance from term lending
institutions begins with filling up the application form as well as completion of the
feasibility report. The procedure for getting the financial assistance from the all-India term
lending institutions can be divided into three stages: (1) Pre-sanction (2) Post-sanction up
to disbursement, and (3) Post-disbursement and follow-up
Stage I- Pre-Sanction (by IDBI, ICICI) (Fig.2) Enquiry ↓ Calling preliminary information, if necessary ↓ Supply of questionnaire for preparing the application
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↓ Receipt of application for financial assistance ↓ Examining application as to its completeness and receipt of examination fee ↓ In the case of joint financing, ensuring that copies of applications also sent to other institutions ↓ Preparation of summary of applications and soliciting Approvals for processing ↓ Calling promoters for discussion, if required ↓ Calling for credit reports and making prior references to government, etc. ↓ Suggestion/discussion at inter-institutional meetings in the case of joint-financing ↓ Scrutinizing application and issuing questionnaire on technical and financing points arising out of the application ↓ Programming and carrying out site inspection ↓ Preparing appraisal report and memorandum to advisory committee ↓ Advising applicants to depute promoters/representatives
for giving additional information/clarification that might be required by the advisory committee ↓ Consideration by advisory committee ↓ Preparing minutes of advisory committee and board memo ↓ Consideration by Board of Directors ↓ Issuing letter of rejection in case the application is rejected by the Board
Stage II- Post-Sanction up to Disbursement (Fig.3)
Discussion with promoters on important conditions tobe stipulated including the tentative terms of conversion
of a portion of rupee loan into equity. Preparing andissuing letter of intent
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↓Making references to IDBI/Central Government for
approval of sanction, wherever necessary↓
Preparing and issuing draft loan agreement/draft letterof underwriting for approval
↓On approval by applicants board/shareholders/govt.authorities, engrossing loan agreement and sending
branch for execution by an appointment↓
Investigation of title↓
Compliance of terms and conditions and arrangementsand securing of various approvals by applicant
↓Examination of prospects
↓Consideration of terms and conversion of part of rupee
loan into equity capital at the meetings of seniorexecutives of the institutions
↓Deciding the terms of conversion of part of rupee loan
into equity capital at inter-institutional meetings↓
Verification of physical and financial progress↓
Issuing final letter of underwriting↓
Execution of legal mortgage deed, personal guarantee,and other documents and deposit of insurance cover
↓Sanction of interim loan against equitable mortgage
and execution of other relevant documents↓
Disbursement of installments of loan/issue ofguarantee/opening of letter of credit under sub-loans in foreign currency
Stage III- Post-Disbursement and Follow-up (Fig.4)
Collection of interest and Watching progress fromPrincipal of loan/ watching periodical progress
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timely payment of reportsinstallments against deferred payments guaranteed by the corporation
Conversion of loan into Appointment of nominee equity capital in case option directorsis exercised Analysis of balance sheets and working results
Payment of loan in full Periodical inspections
Satisfaction of mortgage Discussions with Representatives of Assisted concerns and Nominee directors by Way of follow- up
Operating Aspects of Financial Institutions (1) Before filling up the prescribed application form, it is advisable that the
entrepreneur meets the senior officials of the financial institutions and has a very frank
discussion on the pros and cons of setting up a particular project.
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(2) Based on the discussions with the executives of the financial institutions the
entrepreneur should prepare a detailed project feasibility report.
(3) The application is then completed by the promoters/entrepreneur. The
application is considered completed if the entrepreneur has the required letter of intent,
clearance of the Capital Goods Committee for proposed import of equipment, and
clearance of the land allocated by the Government for setting up of the project.
(4) The application is then submitted to either one of the financial institutions or
to more than one institution.
(5) The receiving institution then makes a summary of the application as
received and along with its comments, puts it up for a preliminary view to the meeting of
the senior executives of all the institutions who meet once in a month.
(6) At the meeting one of the financial institutions (IDBI, IFCI, ICICI) is
appointed as the lead institution for carrying out the detailed scrutiny of the application.
(7) A team of officers with technical and financial background from the lead
institution is assigned the task of scrutiny of the application. They prepare a list of queries
on which further information is required. At the same time other financial institutions may
also send their list of queries to the lead financial institution. For this purpose the
entrepreneur should send copies of application forms to all the financial institutions to
avoid delay and bottleneck. The lead institution is not authorized to commit itself on behalf
of the other institutions and that each individual institution has the right to obtain any
information that it may desire, independent of the lead institution. The lead institution only
facilitates the entrepreneur so as to save time and labour.
(8) After the list of queries has been answered the representatives of the
entrepreneur are called for preliminary discussion.
(9) After the discussions, a site inspection is made jointly by the officers of all the
institutions to assess the location, level of development of the land, and the infrastructural
facilities available in the vicinity. A meeting may also be arranged with the local Electricity
Board, Municipality, etc. to assess the availability of utilities in the area.
(10) After the visit to the site, the institutional representatives hold discussions
with the applicant’s representatives at the project office, where details of the information
submitted at the time of application are expected to be readily available. To expedite the
matter, it is advisable that the applicant has the following information ready at the time of
visit by the officers:
(a) Certificate of Government approval.
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(b) Map indicating proposed land/site.
(c) Building and plant layout.
(d) Quotations of all the equipment suppliers.
(e) Detailed break- up of the proposed capital expenditure.
(f) Details of all the profitability assumptions.
(g) Any other detail regarding background of the promoters, management setup
and project details that have not been submitted along with the application but may be
required by the officers.
(11) Usually, the scope of the project, list of equipments, project cost, and
profitability estimates are finalized during the visit and tentative financial plan is also
worked out.
(12) The final decision regarding the financial aspects is taken by the
entrepreneur and the senior executives of the financial institutions.
(13) After a detailed scrutiny of all the information submitted by the applicant
and discussions with his representatives, the institutions officers prepare a full report of
their findings. This report, if necessary, may be put before a committee of experts.
(14) The lead institution prepares a memorandum and presents it either at the
Senior Executive Meeting (SEM) or at the Inter Institution Meeting (IIM) and at the
meeting each institution indicates the extent up to which it is willing to assist the company
and sharing so decided is communicated to the applicant by the lead institution, so that the
applicant can start follow- up action with the other institutions for their assistance.
(15) The memorandum placed at the SEM/ IIM is next placed before the Board/
Executive Committee of the lead institution to obtain legal sanction of the assistance. Some
of the other institutions obtain adequate copies of the memorandum from the lead
institution for placing before their own board while other institutions prefer to write out
their own memorandum for placing before their board. In the latter case, the applicant may
be called upon to submit some additional information.
(16) The all India financial institutions provide the following type of financial
assistance:
(a) Underwriting of shares/debentures
(b) Direct subscription to shares/debentures
(c) Guarantee to equipment suppliers
(d) Long term loans
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(17) After the respective boards of the institutions approve assistance to the
applicant, a letter of intent is issued which in a sense conveys willingness of the institution
to provide the assistance, subject to the terms and conditions listed above. The letter of
intent is not, however, a legal document and does not bind the institution to grant
assistance.
(18) The next step is formal acceptance of the terms and conditions by way of a
letter. The institutions take up processing of legal formalities which include the following
points:
(a) Finalization of share issue prospectus.
(b) Examination of the title deeds for creation of security in the institutions favour.
(c) Other relevant matters.
(19) Each institution has is own list of approved solicitors who examine the title
deeds on its behalf and provide assistance.
(20) Disbursement: It sometimes happens that while the deeds of agreement have
been signed, certain terms and conditions are yet to be fulfilled, e.g. the formalities for
creation of the security are yet to be finalized. In these circumstances, the institutions agree
to make an interim disbursement.
(21) During the period of implementation, the assisted company is required to
keep the institutions posted about the progress of the project. To facilitate reporting, a
standard form has been designed by the all-India financial institutions which are just
gaining popularity. During the period of implementation, the institutional representatives
may sometimes visit the project site to assess the progress.
(22) Follow-up: Consequent upon the completion of the project, the institutions
keep in touch with the company until the loan is fully repaid or as the institution holds
shares in the company. The assisted company is required to submit information on its
working, every quarter, on the prescribed forms.
(23) In addition, it is incumbent upon the company during the currency of the
institutional assistance to obtain approval of the institutions for the following:
(a) Utilization of financial assistance from any organization.
(b) Creation of charge on any of its assets in favour of any other party.
(c) Issue of additional share capital in any form or manner.
(d) Change in the full-time director’s remuneration.
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Risk Minimization Risk minimization lies at the heart of Project Finance. Project Finance is providing
finance for particular projects, which are later repaid from cash flows generated by those
specific projects.
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Risk Management Risk Management is the process of Identification, Measurement, Monitoring and
Control and Mitigation of risks. Risk Management aims at Risk Minimization and not Risk
Elimination.
Risk Risk is defined as a possibility of adverse impact on earnings and capital on account
of expected or unanticipated event. Risk and Time are opposite sides of same coin, for if
there were no tomorrow there would be any risk. Time transforms risk and the nature of
risk is shaped by time horizon.
Risk Minimization Process Risk arises due to projects if not being completed on time or within the specified
budget, not operating to their full potential, or failing to generate sufficient revenues to
repay loans, or else getting terminated prematurely. To prevent the above events from
occurring and adversely affecting the project, a three step risk minimization process can be
implemented.
STEP ONE: RISK IDENTIFICATION AND ANALYSIS 1.Project sponsors can prepare a feasibility report, which is carefully reviewed by
financiers in consultation with experts.
2. Financiers particularly look at the correctness of cost estimation and the accuracy of
future cash flows.
3. Several financial models are then used to identify risks, which could affect the
repayment capacity of the project.
STEP TWO: RISK ALLOCATION 1. Risks, on identification, must be allocated to the appropriate parties who have the
financial ability to bear them.
2. Financiers look at allocating risks to such parties, who have an interest/stake in the
concerned project.
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STEP THREE: RISK MANAGEMENT1. Project risks must be managed to minimize the probability of the risk event occurring.
2. To minimize the consequences in case if the event occurs.
3. The higher the risk involved, the greater the control that financiers have over the project.
Types of Risks 1. Completion Risk:
Design and Construction phase involves Completion risk.
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Completion risk involves the risk of not completing a project on schedule due to time,
budget, or technological constraints. Such events lead to delay in loan repayment and debt
accumulation.
To minimize risk before lending……..
a. Obtain completion guarantees from sponsors, requiring them to pay all debts if
completion is not on schedule.
b. Ensure significant financial interest of sponsors in the project to maintain their
commitment.
c. Ensure that the project is developed under the terms of fixed price and time, under the
supervision of reputed developers.
2. Resource Risk: Operation Phase involves Resource risk- Risk of shortage of inputs to generate adequate
returns.
To minimize this kind of risk:
a. Experts reports must certify the existence of inputs.
b. Ensure long-term supply contracts for inputs as a protection against shortages or price
fluctuations.
c. Obtain guarantees for minimum input levels.
3. Operating Risks: Operating risks are risks affecting cash flows and generation capacity of
projects, such as inefficiencies in operations, shortage of skilled labour etc.
Prior to lending, the risks can be minimized by ensuring that a reputed and
financially sound operator is in charge of the project.
During the loan period, detailed operations showing the utilization of acquired funds
should be prepared. This helps ensure that the funds are being utilized for permitted
operating costs only.
4. Market/Off Take Risks: Market/Off Take Risk is a type of risk of not finding a buyer at the fixed price
to generate adequate cash flows.
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This kind of risk is minimized by entering into a forward sales contract with a
financially sound company.
5. Credit Risks: Credit risk involves the repayment capacity of the borrower. This kind of risk
could be minimized if the financier obtains a certificate of satisfaction with regard to
experience, personnel, and financial soundness.
6. Technical Risks: Technical risk involves the risk of technical difficulties in construction and
operation of the projects plant. It can be minimized by mostly adopting new proven
technologies.
7. Currency Risks: Currency Risks involves depreciation in loan and revenue currencies causing
an increase in costs and decrease in cash flows. This risk can be minimized by entering into
suitable hedging contracts, matching the currencies of supply contracts.
8. Approval and Political Risks: Approval and Political Risk involves political and economic instability. Also,
affect on the project due to events causing political instability. By adhering to the law and
complying with necessary procedures these risks can be minimized.