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Chapter 1 : INTRODUCTION
Infrastructure development is the backbone of the economy and progress of any country.
Conventionally the central and state government used to provide funds for its construction
and provide the generated facilities to user (public) either free or at highly subsided rates. The
funds were provided from tax revenue through budget provisions. Apart from requirements of
huge financial services, the quality and efficiency of government created infrastructure used
to be low because of bureaucratic way of working and natural apathy and off take
governmental working.
Due to highly increased expenditure on establishment and diversion of public
financial resources towards short term, popular and politically important gains, the
infrastructure development was denied of resources. These demand which have high capital
requirement and have long gestation period, apart from highly risky ventures, hence even
private sector funding was not forthcoming.
Thus new techniques were required to develop for attracting private sector investment in
infrastructure projects. One such technique is BUILT-OPERATE-TRANSFER (BOT) and its
different variants. Under this scheme an infrastructure projects conceptualized by the
government/public. Bids are then invited from private sector to arrange funds, build the
facility and operate over a specified concession period collecting revenue as a toll from the
user to recover the invested capital plus an adequate return on the investment usually 15 to 20
percent. After the concession period the ownership of the created facility is transferred back
to the government. Therefore, the BOT scheme is a limited-recourse project financing
technique for implementing infrastructure projects by using private funding.
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Chapter 2 :INTRODUCTION:
The Literature survey carried out in this section consists of different aspects of risk involved
in BOT projects and they can be studied in following manner:
1. Risk-Defination
2. Risk Classification.
3. Risk Preception/Awareness
4. Project Life cycle
5. Risk life Cycle
6. Risk Assesment
7. Management Cycle
8. Risk response & Mitigation9. 3.1 INTRODUCTION10.
11.In many developing countries, rapid economic growth is outstripping infrastructure
supply. Governments in these countries are unable to fund vital infrastructure
development and rehabilitation, so they are increasingly turning to large international
firms as a source of funding through concession contracts such as Build-Operation-
Transfer (BOT). These firms generally have a greater credit standing and capacity to
finance the large scale projects. If procured properly, the BOT option presents a win-
win-win solution for governments, private sector firms, and the community at large.
From the governments perspective, private sector participation offers off balance-
sheet funding whilst bringing an added advantage of cost and resource efficiency to
the project. From the private sectors perspective, BOT projects present great
opportunities to expand market share and earn higher returns. Finally, thanks to a user
pays system, the community at large does not experience taxation increases.
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12.However, although globalisation has created greater opportunities for construction
companies to expand their market share abroad and earn higher returns, almost 15%
of the 225 global contractors have sustained losses on their international projects
(Diekmann, despite the fact that international projects are generally more profitable
than domestic projects. Such losses can mainly be attributed to the difficulties
experienced in assessing and evaluating the impact of non-financial (risk) factors on
international projects and more specifically on BOT projects in developing .
13.BOT projects are by nature long-term investments involving complex organisational
structures. Over the lifespan of these projects the legislative, political, social, market
and economic environment could all change significantly. This is especially the case
in developing countries, where the social, political and economic conditions are
unstable. Thus a high degree of risk and uncertainty surround BOT investment
opportunities in these countries and it is critical that adequate identification,
assessment, and evaluation of non-financial (risk) factors take place at the feasibility
stage.
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CHAPTER 4
4. DATA COLLECTION & ANALYSIS
4.1INTRODUCTION
This chapter deals with the details & information of causes & different types of risk
involved in the BOT projects considered for the studied, The data is collected from Mumbai
based Construction Company GAMMON INDIA LIMITED (minimum two projects are
taken to identify different financial risk involved in Project.
The factors that are highlighted in this section are risk during different stages of
projects such as gestation development-construction-operation termination stages. Details
of the project are collected from the two location and the details are discussed from the
project incharges of the project and key person to identify the different factors and various
terms involved in the project..
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4.2 DETAILS OF DATA COLLECTED
The data collected from the sites are as follows.
Project I-
Project Name: - Construction of twin flue Chimney 275mtr Ht.
Client :-Tata Projects Limited
Owner :-MAHAGENCO
Project Cost :166 Crs.
Location :Deepnagar ,Bhusawal.(MH)
Project II-
Project Name:-Construction of Multi flue Chimney 275 mtr Ht.
Client :L&T power Vadodara
Owner: MPGENCO
Project Cost :177crs
Location:Malwa,Shingaji TPS,Khandwa (MP)
4.3 DATA COLLECTED FOR FINANCIAL RISK OF PROJECTS
INTRODUCTION
Risks are nothing more than the variables or circumstances associated with the
implementation of a specific project that has the potential to adversely affect the development
of the project or the interests of participants, as the case may be. Risks include circumstances
or situations or situations, the existence or occurrence of which, will, in all reasonable
foresight, result in an adverse impact on any aspect of the implementation of the project.
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4.3.1RISKS INVOLVED IN DIFFERENT PROJECT STAGES.
It is also generally true of all infrastructure projects that the degree and nature of risks
will alter with regard to the stage of the project. The risks in various stages of a project are
discussed below. Chart 4.1
RISK STAGE OF PROJECT
% RISK
INVOLVED
(Project I)
% RISK
INVOLVED
(Project II)
Value
in Crs
( Project I)
Value
in Crs
( Project II)
Gestation Stage 5% 5% 8.30 8.85
Development Stage 15% 15% 24.90 26.55
Construction and The Start Up Stage 40% 40% 66.40 70.80
Operational Stage 25% 25% 41.50 44.25
Termination Stage 15% 15% 24.90 26.55
Table 4.1
5%
15%
40%
25%
15%
DIFFERENT
RISK INVOLVED IN BOT PROJECT STAGES
Gestation Stage
Development Stage
Construction and The Start Up
Stage
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TABLE 4.1 RISK DURING DIFFERENT STAGE OF PROJECT.
4.3..1 In the Gestation Stage
This is the crucial stage in the process of project implementation, the importance of
which is somewhat misjudged. If the research and the decisions to be undertaken at this stage
are faulty they will to have to be rectified at a later stage of development that would only be
more expensive. In order to verify the feasibility of the project and to enable a project to have
a sound foundation
In the gestation stage the following studies should be:
i. Identification and Analysis of the legal framework that would governthe project s
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ii. Commercial and Economic Feasibility analysis
iii. Environment and Social Impact
A preliminary study should be undertaken regarding the environment impact of
the project and the extent of the possible displacement of people, and requirements for
the habilitation of the persons likely to be displaced.
4.3.2 In the Development Stage
If necessary, the prospective sponsor has to identify suitable co-sponsors. The
proposal of the concerned prospective sponsor is accepted then theProject Vehicle has to be
incorporated.Chart 4.2
Certain Risks during Development Stage:
The most favored solution for mitigating risks at the development stage is generally
for the government to adopt transparent selection procedure (generally competitive bidding
process) on basis of well-defined and adequatelyprepared documents and data. From the
gestation stage itself thegovernment must associate itself with competent advisors in order
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to ensure that the bid documentation and data are reliable and stand the test of time and
examination.
4.3.3 In the Construction And The Start Up Stage
During the construction stage the risk associated with an infrastructure project are the
maximum. This is because at this stage, all the money required to commence the project has
already been drawn or committed for. The success of project completely depends upon the
ability of the contractors, associated in the construction of the facility, to complete their tasks
in a coordinated manner in accordance with the terms of the construction contract. What is
critical at this stage is that the construction of the facility should be completed within the time
period and costs projected for the construction of the concerned project facility. The facility
should comply with all the standards and specifications stipulated in the project document.
The risks associated with technology and used for the construction of the facility
essentially relate to obsolescence of technology, thereby resulting in a relatively poorer
quality infrastructure facility and change in construction costs due to alteration in the
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technology being used.
4.3.4 In the Operational Stage
During the operational phase of a project the risks are more clearly identifiable and relatively
lesser in degree.
Certain Risks during Operation Stage:
Generally speaking, the risks during the operational phase can be divided into
i. Operation risks,
ii. maintenance risks,
iii. revenue risks and
iv. Personnel risks.
The operating risks relate to conditions of operation of the facility, supply of raw
materials, distribution of off take, plant performance, levels and standards in operation of
plant, interruption of operations due to various reasons, fluctuation in costs associated with
continued operations of the facility and actual demand or usage of the facility. Chart 4.3
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4.3.5 In the Termination Stage
The risks associated with the termination stage of a project relate to the:
i. the very risk of termination of the concession and
ii. Risks associated with the transfer of the infrastructure facility to the grantor of
the concession.
Risk of Termination:
The risk of termination of the concession prior to the stipulated concession period is a
major and real risk that can result in the complete loss of all investment and loan facilities
extended to the project.
Chart :4.4
Risks during Transfer:
The concern for the grantor of the concession is that the facility should continue to
provide the service or commodity or the benefits even after the termination of the concession
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period and the resulting transfer of the facility to the granting authority The main risks that
may affect the transfer of the facility include:
i. method and timing of the transfer,
ii. condition of the facility at the time of transfer,
iii. production and environmental requirements at the time of transfer,
iv. obsolescence of technology at the time of transfer,
v. expense of any changes that have to be made to the facility at the time of transfer,
vi. Acceptance of the facility in its current state by the grantor of the concession at
the time of transfer and other related risks.
Transfer risks can be usually mitigated by stipulating standards of maintenance of the
facility which, if adhered to, through the concession period will ensure that the facility is
transferred in a condition that enables its use for a period of time after the termination of the
concession period
4.4. RISK IDENTIFICATION PROCESS
In any construction project, risks are unavoidable. Project participants are exposed to various
kinds of risk. One of the causes that lead to project failure is the inappropriate allocation of
risks to the various parties in the project. Risk management starts by the identification of the
various types of risk that could be encountered in a project. In order to identify the risks it is
essential to understand what each risk consists of and what the common causes for project
failure are. Understanding the causes for failure and the description of the various risks is a
prerequisite for an efficient risk identification, allocation, and mitigation.
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Chart 4.5
i) CAUSES FOR PROJECT FAILURE
CAUSES OF PROJECT FAILURES
PROJECT I -
Bhusawal
(In Crores)
PROJECT II -
Khandwa
(In Crores)
Capital cost overrun. 12.00 8.00
Technical failure. 9.93 0.50
Financial failure of the contractor 1.20 4.00
Government interference. 0.50 0.20
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Uninsured casualty losses. 0.40 0.00
Increased price or shortages of raw materials. 0.00 12.00
Technical obsolescence of the plant. 2.00 6.00
Loss of competitive position in the market place. 0.00 0.00
Expropriation. 1.40 3.20
Poor management. 2.20 1.20
TABLE 4.2 :CAUSES OF PROJECT FAILURE
4.5 COMMON FACTORS REQUIRED FOR SUCCESSFUL FINANCING OF
BOT PROJECT.
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The following is checklist that should be considered in order to achieve a successful
financing BOT package.
COMMONFACTORS REQUIREDFORCOMPARISION IN FINANCING OF BOT
PROJECT
PROJECT I
(RISK
FACTORS)
PROJECT II
(RISK
FACTORS)
A credit risk rather than equity risk is involved. 3 1
The cost of product or raw material to be used bythe project is assured. 2 3
A supply of energy at reasonable cost has been assured. 1 3
Building materials are available at the costs contemplated. 1 2
The contractor/operator is reliable. 2 1
Management personnel are experienced and reliable. 1 1
Contractual agreement among joint ventures partners, if any, is satisfactory. 3 2
A stable political environment exists; licences and permits are available. 3 2
Country risk is satisfactory. 1 1
Currency and foreign exchange risk have been addressed. 2 2
The key promoters have made an adequate equity contribution. 1 2
Adequate insurance coverage is contemplated. 1 3
Force majeure risk has been addressed. 1 2
Delay/Cost over-run risk has been addressed. 3 3
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The project will have an adequate ROE, ROI, and ROA for the investor 3 2
TABLE 4.3 :COMMON FACTORS REQUIRED FOR FINANCING OF PROJECT.
Study explains the criteria for a successful project financing mentioned above. Some
of these criteria may not apply for certain specific projects. The project sponsors
should tailor the criteria to each project case.
Aove chart defines different risk factor level involved intwo projects as follows:-
A. Credit risk -An objective of many project financing is high leverage of the debt to equity
ratios. However, more than a lending risk is involved when the borrower approaches the
lender. A spread in excess of about 300 points over libor is generally considered by most
project lenders as excessive lending risk is involved. Low credit risk makes it easier to raise
equity capital and loans for BOT projects. The usage of a reliable contractor consortium
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could improve the credit risk of the project. Project sponsors reduce this risk by providing
guarantees. This will be discussed in later sections.
B. Cost of product or raw material
Supply sources and contracts for feed stocks or raw material to be used by a project
must be assured at a cost consistent with the financial projections. Long-term take-or-pay
contracts are sometimes used to ensure a user a source of supply. Project dependents can use
a put-or-pay contract, in which the supplier is obligated to provide the product or service at
certain prices over a period of time.
C. Supply of energy at reasonable cost
A number of project financing got into trouble because of their failure to anticipate
future rising energy costs. Long term price contracts for feed stocks, coal or energy (with
appropriate escalation provision) can be used as a way of limiting this risk. Energy price
escalation should be carefully considered in the feasibility study of the project.
D. Availability of building materials
The actual cost of building material should be consistent with the estimated cost. The
ability to import building material and machinery should be established. Existing or possible
embargoes for political reasons must be considered.
E. Experience and reliability of the contractor and operator
The contractor must have technical expertise to complete the project. The contractor
should be financially strong. He should also be large enough to have the resources to solve
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any problem which might arise. Usually, lenders to a project require a contractor with an
established reputation for building similar projects. The operator must have the financial and
technical expertise to operate the project in accordance with the cost and production
specifications which form the basis for the financial feasibility of the project.
F. Experience and reliability of management personnel.
Good management personnel as well as experienced operating personnel are
needed to operate a project. The general management of a project company makes the basic
policy decisions, arranges the financing and is responsible for monitoring the project
company.
G. Contractual agreement among joint ventures partners, if any.
If the project is a joint venture, the agreements between the partners are of
considerable concern to lenders, who want assurance as to the identity of the companies and
entities which will own and operate the project throughout the life of the loan.
H. Stable political environment
The need for a stable political environment is a necessity for a successful project
financing. Permits must be readily available. It is very difficult to measure political stability.
There exist some rating agencies that describe a country's risks as described in the next
section. Sometimes, this information helps to assess political stability level.
I. Country risk
There should be no risk of expropriation. Country risk should be satisfactory.
Country risk is usually defined as a risk of a lender making a cross border loan to a private
company. Country risk problems occur when the host country is not in an economic position
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to permit transfer of amounts of currency for payment of interest and principal on foreign
debt to lenders. Sovereign risk should also be satisfactory. Sovereign risk differs from
country risk in that it refers to the risk of loan to a sovereign nation by a lender located in
another country. This has application in project finance where the sovereign nation is one of
the investors or joint ventures in the project. Country risk is determined by measuring country
credibility. Tables of country risks are produced by various organizations to measure a
country's credibility. An example of such rating is the EIU/Business Risk International rating
where countries are classified into four categories ranging from 'A' (Less risky) to 'E' (More
risky) based on the country's international standing. Another rating used is the one prepared
twice a year by "Institutional Investors" to assess country risk using a scale of 0 to 100.
J. Currency and foreign exchange risk
Currency risk arises where revenues, expenses, capital expenditures and loans are in
more than one currency, and therefore the project is subject to potential losses from currency
fluctuation. Careful analysis should be made of the expected cash flow of a project to
determine what currencies will be used to finance the project, including the host country
currency, and what currencies will be generated by the project. Hedging in the forward
currency market should be done where possible. Swaps can also be used to hedge foreign
exchange exposure. A multi-currency loan may help control this risk.
K. Adequate equity contribution by the key promoters
The key project sponsors or promoters must make equity contributions consistent with
their capability and risk of the project. Lenders will require the sponsors of the project to
have sufficient financial interest in the project so that it will difficult for the sponsors to
abandon or ignore the project. Usually, lenders require an equity contribution of 20% on
average as an indication of sponsors' commitment to the project.
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L. Adequate insurance coverage
An insurance coverage is important during construction and operation of the project.
This provides protection against risks. Usually insurance proceeds are assigned to lenders.
Loan agreements include clauses that determine how the to restore the project or to repay the
debt to the lenders in case of a casualty loss.
M. Force majeure risk
Force majeure risks results from events beyond the control of the parties in the
project. These events may include fire, flood, war, strike, expropriation and political
interference.
N. Cost over-run and construction delay risks
Cost Overrun risk occurs when the cost of construction or completion of a project
facility is larger than the original estimation. This creates a serious problem because the
ability of the expected revenues to cover operating costs and amortize debt is dependent upon
the assumed cost of the project. Overrun risk can be covered in a variety of ways: additional
capital bysponsors, standby credit facility, fixed price contracts, and sponsor's escrow funds
for completion. Adelay in completion of a project facility creates a serious problem. Interest
on the loan continues to run, thus raising the capitalized costs of the project. At the same
time, the expected revenue stream is delayed. Methods of handling cost of delay are the same
as for capital cost over-runs.
O. Adequate ROE, ROI, and ROA for the investor
The return on equity, return on investment, and return on assets are useful measures
used by lenders and investors in estimating the return in a BOT project. Although it is
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difficult to alter the risk of a project, the allocation of the various risks to the parties best able
to handle them reduces the project risk. Table 6.1 summarizes the major risks involved in
infrastructure projects. Different procurement methods involve different risk exposure as seen
in the table. The BOT model involve more risk than the traditional design-build (DB) and the
design-build-operate (DBO) models. Mainly, the more the involvement of the private sector
in the financing of the project, the greater is the exposure to risk. Therefore, in the BOT
model, it is very critical to consider the various types of risks in order to assure success of the
project. Also, the more the project is segmented, the less are the risks involved. The DB
model which is known as the direct funding segmented approach involves less risk than the
other models. The DBO model, which is the direct funding system approach, involves less
financing risks because it is funded by the public sector, but it involves other risks as
described in the table.
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CHAPTER 5
DISCUSSION & SUGGESTION
On the basis of above studies the following are the conclusion and recommendations.
5.1. DISCUSSION & SUGESSTION
1. For the project sponsors to structure a winning proposal based on the BOT approach a
number of prerequisites are required; strong government support, stable currency,
stable economy system and the project must be technically feasible and financially
viable.
2. Considerable co-operation between the government and the private sector institution
is essential. For each of the project participants to take risk, they are better suitable
commercially and politically.
3. Due to complexity of introducing and implementing BOT policies, an institutional
framework should be set up to plan, analyse, implement and process of BOT scheme.
4. Responsibility for construction cost and time over runs should lie with the contractor.
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5. The project sponsors must evaluate and allocate the financial, political and technical
risks to the various parties involved and each participant must have sufficient
contractual incentives and securities to be committed to the project.
6. The participation of private sector in the provision of infrastructure project has
potential of increasing the standard of living of the population. It stimulates supply
and improves the quality of service.
7. The participation is fraught with risks due to lack of experience or recent experience
of the parties regarding these systems, as well as the complexity of the relationships
among the parties.
8. The proper allocation of risks should be done among the parties. This should be done
properly and with great care.
9. Before awarding BOT project to any contractor, detail study about his history, his
capacity of projects of same scheme, his assets, any court cases pending against his
name, his bank statements, problems involved in his ongoing projects should be done.
10.Participation of private parties saves the funds of government which government can
use for social aspects and for development of country.
11.The foundation of successful financial structuring of an infrastructure project is to
structure its funding by providing the different classes of investor with instruments
that match risk/return characteristics best suited to their appetite or requirements.
12.Thus senior debt would have the highest debt service priority and would be best
secured; in ream it would for the longest debt maturity and have the lowest relative
interest spread.
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13. This category of debt would attract banks and other financial institutions.
Subordinated debt or mezzanine finance, possibly with equity kickers', and preferred
equity instruments, would pay more and would be attractive not only to bankers
financial institutions but possibly also to equipment vendors and financial investors.
14. Equity, apart from the sponsors or developer's holdings, could be held by constructor
financial investors, suppliers and off-take purchasers.
15.Once the financing structure is developed, the project company and investor may be
able to make use of and incorporate a number of techniques and instruments to
manage the various financial risks to which each is exposed.
16.The various recommendations given by us to overcome the financial risk in BOT
projects, as innovative financing are as follows.
Insurance
Future and Options
Swaps- Commodity Swaps, Commodity-Linked Loans and Commodity Linked
Bonds
Contingent Bonds
Convertible Bonds
Credit Derivatives.
Securitization
Equity Derivatives
Risks in Hedging
17.Use of above mentioned instruments is not extensive; worldwide and more so m
India. But they do give us an opportunity to mitigate some perceived risks, in their
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nascent stages; they require regulatory and legal changes. Also it requires a stable and
secondary market. Government has to play an important role in this.
SUMMARY TABLE FOR BOT RISK IS AS FOLLOWS TABLE 5.1
BOT RISK SUMMARY TABLE
Stage Risk Participant Mechanism
Development
stage
Technology
Risk
Sponsors
Equity
Subordinate Debt
Credit Risk Sponsors,Lendors Credit rating agency
Bid risk Sponsors Equity
Constructionstage
Completion
Risk
Contractors
Performance Gurantees
incentives
Sponsors
Turnkey Contracts
Contractors
Cost overrun
Risk
Sponsors Fixed price contract &
completion bondContractors
Performance
Risk
Sponsors Perfomance bond
Operationstage Cost overrun
Risk
Sponsors Fixed Price Contract
Performance O&M Equity,performance
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Risk Contractors gurantees
Equity Resale
Risk
Sponsors Subordinated Debt
Off take risk Sponsors
Take & Pay,Take or Pay,
Advance payment
Liability Risk
Insurance
company
Insurance Contracts
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5.2. CONCLUSION.
The conclusion have made on above data analysis for construction of chimney from Mumbai
based construction company two different projects of same nature Project I (Bhusawal) &
Project II (Malwa).The comparison is shown in previous chapters long with the pie charts &
comparision charts for different risk involved in the project with respect to different stages of
project.
1. As the above two case study demonstrates, project finance is a viable way to meet the
large capital commitments required to launch major projects in the world.
2. In addition, the need for project finance is expected to grow. The growing number of
project finance participants is evidence that the technique is efficient.
3. It is true that the risks are large; however they can be controlled and mitigated in an
efficient manner.
4. Therefore, the challenge for successful project finance is a correct allocation of risks
to the parties of the project that are best able to handle them.
5. In any BOT project, we should stress that a rigorous risk analysis is necessary before
a project is embarked upon in order to establish the financial and technical feasibility.
6. An understanding of the project risks leads to the formulation of better project plans.
Knowing the magnitude of the possible impact of risk factors,
7. the parties can seek better allocation of the risks through the agreement of suitable
contract clauses and other risk measures.
8. There is always a significant difference between the project risks sponsors believe
lenders should be willing to accept and those risks lenders are willing to accept.
9. Management and sponsors, by virtue of their status, tend to more naturally optimistic
and entrepreneurial and almost always find it frustrating to deal with naturally
cautious bankers (although the bankers would merely describe themselves as prudent.
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10.In conclusion, the BOT model is successful and is increasingly used in various
countries.
11. One major issue that should be carefully handled in BOT project financing is risk
management.
12. This should be done on a project by project basis.
13.The success or failure of any project is highly dependent on an efficient risk analysis,
risk sharing, and risk mitigation.
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