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Why Project Finance Differs From Corporate Finance
Project finance is where project debt and equity is used to finance the project. This is frequently used in large infrastructures and industrial projects and does not require the sponsors of the project to put up their own balance sheets in order to obtain the necessary financing. In general, the project financing is built into the company budget and specific financing is requested based on a projected budget for a single project.
In order to ensure that the project is successful that the budgets are met, there are certain assumptions that are made at the beginning of the project. These often involve educated projections that are obtained from experts. When a plan is drawn up for a project, items that impact the project budget include the amount of people needed to successfully execute and complete the project, material needs of the project and equipment needs. In addition, the end product must also be valued to provide information such as depreciation which would be included in the project management budget. All of this is necessary for effective project cost management.
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Structure of Project Finance
In many cases, a company will create a sub-company in order to take on a large project. This means that the corporate officers are not liable for the debts and potential legal liabilities of the project. Generally, the project sponsors will invest in the equity of the project, whereas a bank or a syndicate of banks provides the necessary loans for the project and its operation. The loans given by the banks are secured by the assets of the project and are repaid entirely from the cash flow that the project will ultimately generate. The assets of the project sponsors or their balance sheets are in no way a part of the financing of the project. All the projects assets including any revenue producing contracts are used to secure the financing. A lien on all these assets allow the lenders to take control of a project if at any stage they feel that the company managing the project is not performing as it should.
Each project is part of a special purpose entity that has been created for the project and this fully protects the assets of project sponsors from any liability arising out of a failure of the project. The project company generally has no other assets other than the project itself. The owners of the project company would make the necessary capital contributions to enable a project to get off the ground and remain financially sound.
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One of the key components in project finance is identifying risks and making necessary allocations of these risks. Risks in a project can be due to technical reasons, environmental matters, financial or economic risks and quite often political risks. This is especially true in the case of developing countries and markets. Companies specialize in these matters and risk taking, then allocate the risks among themselves and arrange for project financing accordingly. In addition financing of projects is distributed among a number of parties so that the risks are distributed. Each party, however, would be a partner to any profits that the project makes. In case the finance costs are very high or the risks involved are very high, sponsors would give sureties so that limited recourse financing is available. Such type of financing was resorted to during the building of the Panama Canal and the development of the gas and oil industry in the United States during the early 1920’s. Each risk component must be carefully weighed for the most effective project cost management. Each of them impacts budgets and up front monies that may be required.
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Financing of power projects and infrastructure projects is secured by the presence of long term power purchase agreements or tolls and taxed that will be available during the life of the project as well as the assets that the has developed. This enables financial institutions or banks to lend the money against some definite future source of revenue that has been tied up in long term contracts. This also helps reduce the risk for investors, spreading that risk to the persons or entities that will make future use of the assets. In most developing countries governments are the primary consumers of the project and ensure the deliverables are distributed to their population whether in the form of power, roads, bridges, water supplies or similar services. In these cases, the government provides a guarantee of minimum revenue to ensure the financial viability of the project.