Organization of the study

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INTRODUCTION
METHODOLOGY
LITERATURE
REVIEW
(Conceptual)
SECONDARY
DATA
(Situational)
CASE STUDIES
CONCLUSIONS
AND
RECOMMENDATION
CONCEPTUAL
FRAMEWORK
Figure 1 - The Organization Chart of Research Study Report
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Chapter 2
Literature Review
Consideration of the risk and return
In project financing
2.1. Project financing - Concept and definition
2.1.1. Definition of project financing
"Project financing is a financing of a particular economic unit in which a lender is
satisfied to look initially to the cash flows and earnings of that economic unit as
the source of funds from which a loan will be repaid and to the assets of the
economic unit as collateral for the loan". [Nevitt,1983]
2.1.2. Interested parties
Project sponsors. They take equity risk in the project and normally have the highest
portion of profit or loss. They are a group of companies and organizations which identify
the market opportunities, then organize and negotiate with other parties to appraise,
invest, subcontract, operate and monitor the project. [Nevitt,1983]
v First group: Corporations, Investment Banks
v Second group: Government agencies, The World Bank (WB), regional
Development Bank (DB), Government Banks
Creditors. They take debt risk in the project and have priority in claim against the
project in the case of default. Creditors can be categorized as senior debtors and
subordinated debtors. They include:
v Commercial banks,
v Institutional Investors,
v Public Investors.
Supplier. The profitability of the project is strongly influenced by the price of
feedstock for project. Relevant uncertainties will be relieved if project gets a long-term
supply contract within certain price limits with supplier. The project-supplier relationship
secures mutual benefit since project is normally a big potential customer for the supplier.
Buyer. For the project this is potential customer, whose promise to buy output of the
project can greatly enhance the credit of the project. The project-buyer relationship also
secure their mutual benefit because the buyer can be sure about the future supply to
itself.
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Contractors. They could be construction contractors or operating contractors. Their
ability to complete construction on time and the ability to operate the project effectively
are two of the major concerns of creditors.
Multilateral agencies are government agencies and international organizations
which provide their support to some large projects specially important for the social-
economic development of a country. The form of this support could be providing of equity
capital, guarantees, concessions, low interest loans, subsidies, and local service, roads,
water, sewers, and police protection.
2.1.3. The process of project financing
µ Preliminary feasibility study
The purpose of this stage is to determine whether the project has sufficient merit to
warrant further expenditure of time and effort to bring it about. Normally, independent
engineering, legal and financial consulting firms are invited to conduct a preliminary
feasibility study, since their judgments are considered subjective and could be easily
accepted by both sponsors and lenders.
A preliminary feasibility study will determine the objectives of the sponsors; review
the plan of the sponsors to see whether the project is both technically and financially
feasible; raise questions and issues which must be answered; and suggest alternatives
ways to accomplish the sponsors' objectives.
µ Planning
In this stage, different scenarios for the financing will:
v be derived based on the preliminary feasibility study and assumptions about term
structure of interest rate, currency exchange risk, inflation risk, debt/equity ratio,
anticipated cash flow, completion risk, political risk, etc.
v be tested and compared to get one optimum funding plan.
µ Arranging the financing
An information memorandum is prepared and presented to prospective lenders with
the following:
v The sponsors and promoters of the project are identified.
v Third party guarantors to the project (suppliers, buyers, contractors, etc.) are
identified.
v Location of the project.
v The estimate of construction cost.
v The financial plan
v The proposed terms for financing (amounts, maturities, and timing).
µ Monitoring and administering the financing
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Cost over-runs and completion delays are the major concerns while monitoring the
project during the construction period. Debt must be taken down to match the financial
plan and construction schedule, and estimates to completion must be prepared from time
to time.
Administration of the loan agreements when implementing financing plans involves
monitoring the actual operating cost and economics against the financial plan and
production goals (market, sales revenues).
2.1.4. Sources of funds
The main sources of funds are lenders and sponsors:
µ Commercial lenders include
v Banks;
v Institutional investors;
v Commercial finance companies;
v Leasing companies;
v Individuals;
v Investment management companies;
v Money market funds.
µ Commercial sponsors are
v Companies requiring products or services;
v Companies supplying a product or material to the project;
v International agencies (WB, DB).
2.2. Different kinds of risk in project financing
Risks related to project financing can be identified separately during various phases
of project lifecycle (Table 2.1).
Table 2.1. Project financing risks during various phases of project lifecycle
Development phase Construction phase Operating phase
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v Bid risk v Political risk v Political risk
v Credit risk v Exchange risk v Exchange risk
v Technological risk v Performance risk v Performance risk
v Market risk v Cost over-run risk v Cost over-run risk
v Completion risk v Liability risk
v Off-take risk
µ Development phase
Bid risk. Because the lenders are not willing to participate in development phase,
sponsors have to provide equity. If the project proposal does not get the approval for its
implementation, the sponsors would loose the money spent in preparing the bid, this is
referred as bid risk. Similarly, financial advisers would have to write off their costs if
project proposal is not accepted. [Nevitt,1983]
Credit risk. This risk refers to sponsors' creditworthiness, which would be supported
by letters of credit from banks. The questions of whether a credit risk or an equity risk is
involved usually arises in connection with the adequacy of the underlying equity
investment in the project, and the risks assumed by the sponsors and third parties.
[Nevitt,1983]
Technological risk. This risk is considered when a new technology is used in a
project. Lenders always try to avoid financing a project using new and untested
technologies on a nonrecourse basis, unless the technological risks can be fully
absorbed by some other parties. The reason is that new technology would increase the
completion risk, cost over-run risk and even the risk of failure of the project.
Market risk. This risk refers to the marketability of a product or service produced
from project operation, and must be considered at the beginning in form of market survey
and research. Competing products, estimated price and volume of the product, future
cash flows, and completion from suppliers closer to the markets, or with less expensive
sources of raw materials, feedstocks or energy are involved in a careful market study.
[Nevitt,1983]
µ Construction phase
Political risk refers to the occurrence of likelihood that a firm will suffer losses
because of political or macroeconomic developments (political risk has the same
meaning as country risk). This risk is difficult to ensure against, although there are
various strategies to avoid it (such as joint agreement with a public partner).
Exchange risk. The major concern for international investors is currency and foreign
exchange risk when cash inflows and cash outflows are realized in more than one
currency. Potential losses may occur due to currency fluctuation.
Performance risk. Final responsibility for a project's performance lies with the
sponsors, who may provide performance guarantees. [Nevitt,1983]
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Cost over-run risk. Cost over-run plagues many projects, and usually have a stand
by facility which is based on the guarantees from sponsors and the additional capital from
sponsors in the form of subordinated loans or through fixed price contractors.
Completion risk involves both contractors and suppliers at construction phase. To
achieve the completion of the project by a certain date, sponsors often provide
performance incentives and guarantees.
µ Operating phase
Most of the risks at the operational phase can be covered through agreements with
the relevant parties. Operating risks can be taken by the operating and maintenance
contractors through a performance guarantees; cost over-run by the sponsors through
fixed price contractors; off-take risk through take-or-pay agreements or advance
payments; and liability risk can be covered through insurance.
Political risks can be classified into two group: extra-legal versus legal-government
risk and macro versus micro risk. Since political risks refer to the probability of
occurrence of the events (which will cause losses to the firm) in the non-market (political,
economic, and social) environment of business, they are difficult to avoid.
2.3. Methods of dealing with risk
2.3.1. Sensitivity analysis
" Sensitivity analysis is a risk analysis technique in which key variables are
changed and the resulting changes in the net present value (NPV) and the rate of
return are observed." [Brigham,1992]
It is clear that many of the variables which determine a project's cash flows are based
on a probability distribution rather than being known with certainty. If a key input variable,
such as units sold, changes, the project's NPV will also change. Sensitivity analysis can
indicate exactly how much the NPV will change in response to a given change in a input
variable, other things held constant.
The analysis technique begins with the so-called base case situation, which is
developed using the expected values for each input. Then the table describing the
deviation from base level of considered variables will be developed. The values used to
develop the table, including units sales, sales price, fixed cost, and variable cost, are
most likely, or base case, values, and the resulting project's NPV is called base case
NPV. Deviation from base level is usually: -10%; +10%; -20%; +20%; etc. All NPVs will be
used to construct the graphs. The slopes of the lines in the graphs shows how sensitive
NPV is to changes in each of the inputs.
Sensitivity analysis is probably the most widely used risk analysis technique, however
it has limitation due to not considering the range of likely values of key variables as
reflected in their probability distributions.
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2.3.2 Scenario analysis (Probability analysis)
"Scenario analysis is a risk analysis technique in which "bad" and "good" sets of
financial circumstances are compared with a most likely, or base case, situation."
[Brigham,1992]
Scenario analysis considers both:
(1) the sensitivity of project's NPV to changes in key variables and
(2) the range of likely values of these variables as reflected in their probability
distributions.
In scenario analysis, all of input variables are set for three cases:
(a) at their worst reasonably forecasted values (e.g. worst case scenario);
(b) at their best reasonably forecasted values (e.g. best case scenario); and
(c) at their most likely values (e.g. base case).
The worst case variable values are used to obtain the worst case NPV and the best case
variable values to obtain the best case NPV. The expected NPV can the be determined
based on estimate of the probabilities of occurrence of the three scenarios, the p
i
values,
as follows.
Expected NPV = p
1
(NPV
1
) + p
2
(NPV
2
) + p
3
(NPV
3
)
Where: index "1" denotes worst case;
index "2" denotes base case;
index "3" denotes best case.
The standard deviation of NPV (σ
NPV
) and the coefficient of variation (CV
NPV
) are
determined based on expected NPV and NPV
i
.
Scenario analysis can provide good information about project's stand-alone risk.
There is however, a limitation of this technique in that it only a few discrete outcomes
(NPVs) are considered for the project, even though there really are an infinite number of
possibilities.
2.3.3. Monte Carlo Simulation
"Monte Carlo Simulation is a risk analysis technique in which probable future
events are simulated on a computer, generating estimated rates of return and risk
indexes." [Brigham,1992]
To prepare a computer simulation, the probability distribution of each uncertain cash
flow variable must be specified first. Once this has been done, the simulation follows the
following steps:
1. The computer chooses at random a value for each uncertain variable based on
the variable's specified probability distribution.
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2. The value selected for each uncertain variable, along with values for fixed factors
such as the tax rate and depreciation charges, are then used by the model to
determine the net cash flows for each year, and these cash flows are then used to
determine the project's NPV in the first run.
3. Steps 1 and 2 are repeated many time, say 500, resulting in 500 NPVs, which
make up a probability distribution.
The resulting NPV distribution is graphed to determine the expected NPV, σ
NPV
, and
CV
NPV
for any set of assumptions.
The primary advantage of simulation is that it show the range of possible outcomes
along with their attached probabilities, rather than merely a point estimate of the NPV.
However, this technique has not been widely used in industry. One of the major problems
is specifying the correlation among the uncertain cash flow variables.
2.3.4. Utility theory
"The utility of a sum of money can be defined as its relative degree of usefulness
or desirability to the decision maker".[Merrett,1976]
Utility theory suggest a way of not having to rely on the long-term averages, but still
retaining a probabilistic framework of the analysis in the face of risks which are large
relative to the risk-taker's resources. Utility theory attempts to provide a formal
framework for measuring the subjective value of sum of money in a given situation. It is
not the expected monetary value of a decision that the maker should be trying to
maximize, but rather expected value to him/her, that is its expected utility value.
Experiments have shown that the individual's own utility function is likely to reflect
his/her own risk horizon based on the sum of money he/she is accustomed to deal with
for his/her firm. An executive who often settles issues involving hundreds of thousands of
dollars is likely to have a linear function in the low hundreds of thousands, with the curve
flattening and dipping above and below the positive and negative ends of such range. His
superior, who deals in millions, usually has the same shaped function but his linear range
covers the low millions. The chief executive of this multi-million dollar firm may think of a
two to one on gamble for plus or minus $10 million acceptable, but applies much heavier
weights against losses and gains above and below that mark.
Utility theory applies mainly to the few relatively large projects which by definition
have unique features. Further, utility curves can be drawn up only for relatively simple
gambling situations, and these fail to reflect the many complexities
2.3.5. Decision trees
"The decision trees is a network diagram approach to analyzing the value of
information, particularly applicable to investments characterized by high
uncertainty and requiring a sequence of related decisions to be made over a
period of time". [Merrett,1976]
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It is possible to take the decision with the information which already exists, but if the
decision maker can obtain more information, he/she may possibly to reduce the degree
of risk attaching to the decision such as project financing. A problem is whether or not to
purchase information about the likely outcome of an investment proposal before finally
committing to one course of action or another.
It is clear that information is rarely free and available. It generally costs both money
and time to obtain. There is unlikely to be certainty that after paying for the additional
information, it will reduce the risk. So the decision maker is faced with an expensive delay
resulting in an uncertain decrease in uncertainty. This delay will only been justified if it
causes him/her to change the decision he/she was going to make anyway into a better
one.
It is possible to display the complexities of such a decision with an information flow
diagram - the so-called decision tree(s). This diagram is applicable to investments
characterized by high uncertainty and requiring a sequence of interrelated decisions to
be made over a certain period of time. The more complex the chain, the more essential
becomes the use of such technique.
The concept of the network diagram is also used where the sequential decisions
which are mapped out do not necessarily involve the purchase of further information. This
display technique helps to outline the options open to a decision maker and the likely
logical action to take at each decision point.
An extension of the decision tree approach to include continuous probability
distribution is a further refinement well worth considering for major projects of a complex
nature.
If a decision tree is used as a master plan in outline for the control of the analysis of a
complex problem, it can be well worth the trouble of its construction. Also its role as a
visual aid to the explanation of a complex plan of action to top management justifies its
use by the planer.
2.3.6. Game theory
"Game theory is intended to provide a logical framework for the study of the
strategies open to the decision maker in the face of total uncertainty. Various
objectives can be still studied with an advantage even under these conditions,
such as the minimization of the risk of loss, the maximization of the chance of
gain, or the minimization of the regret the decision maker may suffer from having
not chosen the outcome the turned out to be the best". [Merrett,1976]
Primarily, game theory is concerned with the conditions of limited information which
apply in game situations and is concerned to provide rules for decision taking in
situations in which probability theory is not applicable due to absence of probabilistic
information. The principle of game theory can be explained in following example.
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An investor is faced with a number of possibilities A
1
, A
2
, A
3
, A
4
, A
5
, etc., and there
are a number of states of the world possible S
1
, S
2
, S
3
, S
4
, etc., whose affect on each
outcome, as measured by an NPV, can be calculated. Where:
+ A
1
, A
2
, A
3
, A
4
, A
5
are the alternatives as different sized hotels proposed to build;
+ S
1
, S
2
, S
3
, S
4
are the different socio-economic situations when the hotels come in
service.
These possibilities could be arranged in the form of a matrix (Table 2.2). There are
some criteria for selecting the size of the hotel: (1) Minimax, (2) Maximax, and (3)
Minimization of the regret.
Table 2.2 NPV under various situations (A
i
,S
i
)
STATES OF THE WORLD
Possibilities S
1
S
2
S
3
S
4
A
1
100 90 80 70
A
2
200 180 160 150
A
3
170 250 240 190
A
4
10 210 400 380
A
5
(60) 110 310 460
µ Minimization of the risk of loss (Minimax)
The investor should choose the "best" worst case. Arraying the worst cases for each
alternative he gets A
3
which is clearly the best choice on this criterion (Table 2.3).
Table 2.3 NPV in the "best" worst case
STATES OF THE WORLD
Possibilities S
1
S
2
S
3
S
4
A
1
70
A
2
150
A
3
170
A
4
10
A
5
(60)
µ Maximization of the chance of gain (Maximax)
Maximax means selecting the most favourable case among the best available ones.
Table 2.4 NPV in the "best" best case
STATES OF THE WORLD
Possibilities S
1
S
2
S
3
S
4
A
1
100

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