Project finance is a form of debt financing that is used to fund large-scale infrastructure projects. These projects often require a substantial upfront investment and do not generate a return until the construction phase is complete. Project finance can be beneficial for many reasons, but it also has its risks. These risks can include currency risk, failure to reach planned design capacity and unforeseen construction costs.
Cost-Effectiveness
Cost-effectiveness analysis is a tool that helps you determine whether a project is worth your money. It doesn’t just look at the costs involved, but also how your investment will impact your business in the long run. Using cost-effectiveness analysis allows you to identify opportunities for improvements that could make a substantial difference in your business. For example, a study showed that the use of oral rehydration therapy could save more than a million children from dying of dehydration each year.
Another key benefit of cost-effectiveness analysis is that it helps you to identify areas where resources are being wasted. This can help you to redirect your efforts and avoid projects that aren’t worth the expense.
Shared Risk
Project Finance relies heavily on cash flows and the contractual arrangements that support them. These arrangements must be based on a sound appraisal of the risks involved in a project and their management. Project risk analysis is a complex process, which requires input and advice from accountants, lawyers and other experts. Without such an analysis, lenders cannot decide who should bear which risks and on what terms and at what price.
Collateral risk (also called credit risk) is a typical project finance risk, which can be managed through the use of collateral. This can help banks to ensure that their investments are protected from changes in the value of assets, and can also be used as a refinancing tool. Governments, investors and private debt financiers can share project risks through the use of an alliance contract where government commits to providing additional ‘contingent’ equity funding as the project reaches financial close. This arrangement is commonly used to address security issues, including foreign exchange risk and political risk.
Limited Impact On Balance Sheet
The balance sheet of project sponsors or investors is typically not impacted significantly by the financial obligations they incur. This is because the debt they hold for the project is usually held by a separate minority subsidiary, which is not consolidated on their own balance sheets. This enables the shareholders to use their debt capacity for other investment activities without having to reduce their debt levels or risk being wiped out by a failed project. This limited impact on the balance sheet is an important factor in attracting private financing for large-scale development projects that might otherwise be beyond the ability of one party to finance alone, such as a privatization or infrastructure improvement program.
The reliance on Project Finance has grown worldwide, particularly in developing countries, in part due to a shift in economic policy to focus more heavily on the private sector and the creation of new market-based instruments for providing infrastructure services. Nevertheless, a number of factors, including the East Asia financial crisis and ongoing political instability in the Middle East region, have caused some observers to question whether this expanded use of project finance is appropriate.
The Bottom Lines
Project Finance is a debt financing mechanism used for infrastructure-heavy, capital-intensive or public utility projects. These debts are not recorded directly on the balance sheets of the companies sponsoring the projects, which reduces the impact on their shareholders’ existing liabilities.
