assignment - pm0012 - project finance and budgeting - set 2

Sikkim Manipal University - MBA - PM0012 - Project Finance & Budgeting

Semester: 3 - Assignment Set: 2

Question 1: List the advantages and disadvantage of project finance.

Answer:

Nevitt and Fabozzi (2000) define Project Financing as ‟Financing of a particular economic unit in which lender is satisfied to look initially at the cash flow and earnings of that economic unit, as the source of funds from which a loan will be repaid, and at the assets of the economic unit as collateral for the loan”. International Project Finance Association (IPFA) defines project finance as “the financing of long-term infrastructure, industrial projects and public services based on a non-recourse or limited recourse financial structure, where project debt and equity used to finance the project, are paid back from the cash flow generated by the project”. The project, its assets, contracts, internet economies, and cash flows are separable from its promoters or sponsors and are used to permit credit appraisal independent of the financial strength of the sponsors. Attractiveness of the project finance lies in its ability to fund projects off balance sheet, with limited or non-recourse to the equity investors. If project fails and they are unable to pursue equity investors for liability, lenders recourse is to take ownership of the actual projects.

Advantages and Disadvantages of Project Finance: Project finance entails significant countervailing benefits to offset the incremental transaction cost and time. Yet, the academic practitioner fails to understand and accurately depict these benefits. As it is true that leverage raises expected equity returns, the motivation for using project finance fails to recognize the fact that higher leverage also increases equity risk and expected distress costs. However, it is argued that project finance solves two financing problems: Reduces the cost of agency differences inside project companies. Decreases the opportunity cost of underinvestment due to leverage and incremental

distress costs in sponsoring firms.

The major advantages of project finance are: Allows the promoters to undertake projects without exhausting their ability to borrow

amount for traditional projects. Limits financial risks to a project to the amount of equity invested. Enables raising more debts as lenders are sure that cash flows from the project will not be

siphoned off for other corporate uses. Provides stronger incentives for careful project evaluation and risk assessment. Facilitates the projects to undergo careful technical and economic review. Eliminates the dependency on alternative nature of funding a project. Facilitates the arrangement of liability financing and credit improvement, accessible to the

project but unavailable to the project sponsor. Enables the diversification of the project sponsor‟s investments to reduce political risk. Gives more incentive for the lender to cooperate in an atmosphere of a troubled loan. Enables to have prolonged credit opportunities. Matches specific assets with specific liabilities.

Project finance2 primarily benefits sectors or industries where, projects are structured as a separate entity, apart from their sponsors. Let us take the example of a stand-alone production

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plant. This is assessed in accounting and financial terms separately from the sponsors‟ other activities. Generally, such projects tend to be relatively huge because of the time and other transaction costs involved in structuring, and because of the considerable capital equipment that needs long-term financing. In the financial sector, by contrast, the large volume of finance that flows directly to developing countries' financial institutions has continued to be a part of the usual corporate lending kind. All these do not mean that Project Finance is devoid of any disadvantages. The major disadvantages of project finance are: Complexity of the process due to the increase in the number of parties and the transaction

cost. Expensive as the project development and diligence process is a costly affair. Litigious with regard to negotiations. Complexity due to lengthy documentation. Requires broad risk analysis and evaluation to be performed. Requires qualified people for performing the complicated procedures of project finance. Obligations regarding the trust fund account need to clearly specify. Higher level of control which might be exercised by the banks, which might bring conflict

with the businesses or contracts.

Question 2: List and explain in brief the various stages of capital budgeting.

Answer:

Capital budgeting process is largely related to financing, dividend and investment decisions of the firm with a goal in mind. Corporate finance theory was designed with the goal of maximizing the market value of the firm, to its shareholders. It is also known as shareholder wealth maximization. Capital budgeting is related to investments in long term assets. ‘Capital’ refers to fixed assets used in production. ‘Budget’ refers to the plan of inflows and outflows during some period. ‘Capital Budget’ refers to a list of planned investment outlays for different projects. Therefore, capital budgeting is a process of selecting viable investment projects.

Funds are invested in both short-term and long-term assets. Capital budgeting is mainly pertained with sizable investments in long-term assets. These assets may comprise tangible items like property, plant and equipment. Assets may also consist some of the intangible items such as new technology, patents or trademarks. One can distinguish the capital investment project from recurrent expenditures by two features. One of the features of capital investment projects is that they are significantly large. These are generally long-lasting projects with their benefits or cash flows spreading over many years. Sizable, long-term investments in both these assets have long-term consequences.

Various stages of capital budgeting:

Identification - Identify which types of capital expenditure projects are necessary to achieve the organization's goals, objectives, and strategies.




Search - Explore several different capital expenditure investment alternatives that have the capacity to achieve the organizational objectives and strategies.

Information-acquisition - Analyze the predicted costs and consequences of the alternative capital investments. Information should be both qualitative and quantitative.

Selection - Choose projects for implementation. If there are several suitable projects, this could require ranking projects in terms of priorities. A single project hurdle rate is chosen and used to discount the costs and benefits of the various projects, thereby allowing management to compare the projects.

Financing - Obtain project finances. Determine whether internal financing (cash flow from operations) or external financing (debt or equity) is necessary. In large organizations, this is the responsibility of the treasury department.

Implementation and control - Initiate selected projects and monitor performance. This should include making sure the project is on time and within budget, and should be followed up by a post-investment audit.

Question 3: Classify projects based on the ways they influence investment decision process.

Answer:

Certain projects are sensitive on the basis of the degree of technical and human difficulty. The technical difficulty involves dealing with technology and related problems such as new and innovative technology, management of technological development, risks and dependencies. While the human difficulty (usually politics)resulting from the interests of internal and external stakeholders or public, who influence the outcome of the project. The internal factors being project resourcing, conflict management and agreement of client and suppliers on what is being delivered as per contract.

Investment projects are classified into three categories on the basis, of the way they influence the investment decision process: independent projects, mutually exclusive projects and contingent projects.

Independent projects: An independent project is one, where the acceptance or rejection does not directly eliminate other projects from consideration or affect the likelihood of their selection. For example, if management plans to introduce a new product line, as well as, replace a machine which is currently producing a different product. These two projects can be considered independent of each other, if there are sufficient resources to adopt both, provided, they meet the firm’s investment criteria.

Mutually exclusive projects: The mutually exclusive projects are projects that cannot be followed at the same time. The acceptance of one prevents the substitute proposal from accepting. Most of them have ‘either




or’ decisions. You will not be able to follow more than one project at the same time. The evaluation is done on a separate basis so that one that brings the highest value to the company is chosen.

Contingent projects:

A contingent project is one where the acceptance or rejection depends on the decision to accept or reject multiple numbers of other projects. Such projects may be complementary or substitutes. Let us take the example of bio fuel plant cultivation in a large scale and the decision to set up a bio fuel manufacturing unit. In this case, the projects are complementary to each other. The cash flows of the plant cultivation will be enhanced by the existence of a nearby manufacturing plant. Conversely, the cash flows of the manufacturing unit will be enhanced by the existence of a nearby cultivation farm.

Question 4: If there is an initial investment of rupees 2000 and 4 years of positive cash flow of rupees 900 each, the discount rate is 12%. What is the present value of each cash flow?

Year Cash FlowY1 2000Y2 900Y3 900Y4 900Y5 900

Answer:

Present Value:

The present value rule -- the future is less valuable than the present. To make decisions now -- really the only kind we make -- it is useful to know the "present value" of future money. Present value is the current dollar value of a future amount -- what would have to be invested today (at a given interest rate over a specified period) to equal the future amount. What is a dollar in the future worth? It depends on when it will be received and our current investment opportunities.

Discounting - a method for determining present value. To arrive at a present value of future money, we need a method that accounts for why current dollars are worth more than future dollars. The mechanism for capturing these elements is the discount rate—the rate at which future cash flows are discounted back to today’s dollars. The discount rate varies in a common-sense fashion:

If receiving cash flows now is important, the higher the discount rate. If the risk of not receiving future cash flows is high, the higher the discount rate. If inflation is expected to rise, the higher the discount rate.

The present value of a single cash flow can be written as follows:

PV = FVn / (1 + i)n

FV The present value (r initial principal)




FVn future value at the end of n periodsi the interest rate paid each periodn the number of periods

This means that if you know what a future payment will be, when it will be made and what interest rate that we would be paid to achieve comparable future payments -- you can compute that payment's present value! Armed with this basic formula, you can compute a present value quite easily if you know what the future payment will be (or is expected to be), when it will be made, and the discount rate applied.

YearCash Flow

Discount Rate Present

Value1 1200 12 1081.082 900 12 730.463 900 12 658.074 900 12 592.865 900 12 Total:534.11

3596.58

Question 5: Write short note on: a) Payback periodb) Discounted cash flow

Answer:

a) Payback period

Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. For example, a $1000 investment which returned $500 per year would have a two year payback period. The time value of money is not taken into account. Payback period intuitively measures how long something takes to "pay for itself." All else being equal, shorter payback periods are preferable to longer payback periods. Payback period is widely used because of its ease of use despite recognized limitations, described below.

The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs. Here, the return to the investment consists of reduced operating costs. Although primarily a financial term, the concept of a payback period is occasionally extended to other uses, such as energy payback period (the period of time over which the energy savings of a project equal the amount of energy expended since project inception); these other terms may not be standardized or widely used.




The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for the time value of money, risk, financing or other important considerations, such as the opportunity cost. Whilst the time value of money can be rectified by applying a weighted average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation. Alternative measures of "return" preferred by economists are net present value and internal rate of return. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment.

It is period is the period in which the total investment in permanent assets pays back itself. This method lists the various investments that are ranked according to the length of their pay-back period and the investment with a shortest payback period is preferred. The payback period can be ascertained in the following manner:

Payback period = Investment-----------------------Flow/year Cash

b) Discounted cash flow:

All organizations face one constant constriction of making use of limited resources to meet their unlimited ambitions. As the demand for higher shareholders‟ worth increases, the pressures on these resources also increase in turn forcing the management to make rational decisions when investing on resources. The project valuation technique ensures suitable cash flow statements and proper usage of the resources.

Discounted Cash Flow (DCF) facilitates the evaluation process. DCF framework helps in accessing the profitability of a proposed project. Commonly every project's value is estimated using a discounted DCF valuation, and the one with the highest value, as measured by the Net Present Value (NPV) is selected.

The evaluation involves estimation of the size and timing of all the incremental cash flows obtained from the project. This analysis is crucial in determining the economic viability of a proposed project and the estimated rate of return that the providers of the capital can attain.

In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs) – the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.

Using DCF analysis to compute the NPV takes as input cash flows and a discount rate and gives as output a price; the opposite process – taking cash flows and a price and inferring a discount rate, is called the yield. Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management.




Question 6: Total cost of project is 150,000Cr. Expected return of project amount is 34,000 Cr. What is the shortest payback period?

Answer:

The payback on an investment shows how long it takes for the investment to pay for itself. Calculating the payback requires knowing the cost of the investment and the annual cash flows from it. The calculation provides investors with an approximate date when the investment's cash in-flows will pay for its cash out-flows. Payback is useful because it gives investors an idea of when to expect to start making money on an investment.

Payback = Cost of project/Expected Annual Cash Inflows

Payback=150 000/34 000

=4.41 years


assignment - pm0012 - project finance and budgeting - set 2

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