Project Finance and Its Techniques | Company | Financial Management

In this article we will discuss about:- 1. Introduction to Project Finance 2. Techniques Used in Credit Appraisal 3. Key Elements for Appraisal of a Project 4. DIC Schemes.

Introduction to Project Finance:

Project finance is a type of loan arrangement in which the repayment is derived primarily from the project’s cash flow on completion, and where the project’s assets, rights, and interests are held as collateral.

In other words, it is a way to finance an activity using debt where the debt is repaid from the funds generated by the activity. For example, project financing may involve issuing a bond to pay for the construction of a shopping mall and repaying it from the retail sales generated when the mall is open and functional.

Project finance is finance for a particular project, such as a mine, toll road, railway, pipeline, power station, ship, hospital or prison, which is repaid from the cash-flow of that project. It is different from traditional forms of finance because the financier principally looks to the assets and revenue of the project in order to secure and service the loan. In contrast to an ordinary borrowing situation, in case of a project financing the financier usually has little or no recourse to the non-project assets of the borrower or the sponsors of the project.

The discipline of project financing includes understanding the rationale for project financing, how to prepare the financial plan, assess the risks, design the financing mix, and raise the funds.

Before financing a project, the financier performs a project appraisal to study the viability of the project. The credit managers of banks and Non-Banking Finance Companies (NBFCs) are duty bound to accept or reject a proposal on the basis of its viability or non – viability.

Project/Credit appraisal is done by banks or financial institutions by obtaining credit information of the borrowing company from the following sources:

1. Bank References:

The information about the borrowing company would be available from those banks where it has accounts. Also, information will be available from the banks that have lend money to the borrowing company in the past. This will provide a picture of the borrowing company’s repayment schedule.

2. Trade Reference:

They are references from the company’s customers, suppliers, etc. Supplier’s information would be particularly useful because, that would give an idea of the usual payment policies of the company.

3. Credit Rating Agencies:

Credit rating agencies provide rating to the company which helps in establishing its credibility in the market.

In India, there are three major credit rating agencies:

(a) CARE- Credit Analysis and Research Limited

(b) ICRA – Investment Information and Credit Rating Agency of India

(c) CRISIL – Credit Rating Information Services of India Limited

4. Company Financial Reports:

The annual reports of the companies that are statutorily prepared and laid before the shareholders are important source of credit evaluation by the financier.

5. Press Reports:

Periodically published financial data, key ratios, etc. helps in finding out the financial position of the borrowing company. The published data also provides details of the company about the share of market, competition, price, sales volume, etc.

6. Stock Market:

The market prices of the listed companies are available on the stock exchange websites. The Price-Earnings ratio gives an idea of how is the company perceived by the common investor.

7. Charges Registered:

The various charges that are existing on the assets of the company are available with the registrar of companies. This again gives an idea of the financial status of the company.

Techniques Used in Credit Appraisal:

1. Personal Discussion:

It will give the financier a primary data about the borrowing company. The objective of the borrower can be clearly understood with a discussion with the company director. The utilization of the funds will be done specifically for which purpose can be clarified in a personal discussion. Nowadays, all banks and financial institutions have a personal discussion with the borrower, even if the funding is for purposes like home loans.

2. Factory Visit:

It will help in collecting the following information:

(a) Operating capacity and existing capacity utilized

(b) Infrastructure and other utilities

(c) Labour relations

(d) Internal control systems

(e) ISO certification

3. Study of Financial Statements:

The financial statements of the company provide information about the liquidity, operating and financial capacity of the company. The authenticity increases in case of audited statements. The goal of such analysis is to determine the efficiency and performance of the firm’s management as reflected in the financial records and reports.

The financier can use various ratios like liquidity ratios, profitability ratios, leverage ratios, efficiency ratios, etc. Also, the lender institution can do inter-firm and intra-firm comparison to understand the trends in the company as well as the industry.

Key Elements for Appraisal of a Project:

1. Legal Framework:

The different legal aspects of the project like licensing issues, Government policies, procurement of permissions, etc. need to be taken care of.

2. Promoter’s Standing:

The capability of the management, the financial background, access to different sources of finance, experience in the project that needs funding should be studied in detail.

3. Technology and Design:

The life of the project, loss due to obsolescence, industry requirements have to be studied.

4. Time Schedule:

The time required for different processes for example, procurement of raw materials, licenses and permissions, establishing a market, etc. has to be considered and accordingly time value of this should be calculated.

5. Market Prospects:

The financier should foresee the demand of the product, the existing level of competition, future prospects of the project, market share, etc.

6. Economic and Financial Viability:

The financier can evaluate the project from different views like pay-back period, Internal rate of return, Net Present Value, etc. and then decide whether the project is financially viable or not.

7. Environmental and Social Compatibility:

The financiers in some cases also study whether the project is harmful to the natural environment. In India, there are no norms as such for Banks and Financial Institutions but in a few countries, the lending institutions consider only those projects which are compliant with environment protection norms.

After the project appraisal is performed on different parameters, the project would be approved if it is financially viable.

Project finance can be provided in the following ways by Banks and Non-Banking Financial Institutions:

(a) Term loan,

(b) Direct subscription/underwriting of equity and debt instruments,

(c) Provide financial guarantee and participate in deferred payment guarantee.

Promoters’ Contribution:

Promoters’ Contribution 30-40% of the total project cost. However, it may differ on case to case basis.

Interest Rate:

The interest rate at which the banks lend to project depends on Prime Lending Rate fixed from time to time. Actual rate within the prevailing rate band depends upon creditworthiness of borrower and risk perception. As of date (May 2011), the prevailing interest rate is 14-16% per annum in Banks. There is provision for certain projects by District Industries Centre (D.I.C.) to provide loans at a rate as low as 4% to 7%.

Security:

First charge on movable and immovable fixed assets.

DIC Schemes:

There are numerous schemes implemented by various State Government Departments/ Corporations such as Social Justice Department, Mahatma Phule Scheduled Caste Development Corporation, Vasantrao Naik VJ/NT Development Corporation, etc. Besides these departments, the Directorate of Industries through its District Industries Centres at District Level and Joint Director of Industries, Mumbai Metropolitan Region at Mumbai, implements Prime Minister’s Employment Generation Programme (PMEGP), Seed Money Scheme and District Industries Centre Loan Scheme for unemployed youth.

There are mainly three schemes viz. PMEGP, Seed Money Scheme and District Industries Loan Scheme implemented by Directorate of Industries for unemployed youth.

The brief features of these schemes are described below:

(A) PMEGP

Coverage: Industry projects upto Rs.25 lakhs investment and service/business projects upto Rs. 10 lacs investment are eligible under the scheme. Project cost will include fixed capital (excluding land cost) plus working capital.

Extent of Assistance:

Extent of assistance 90% loan for general group and 95% for special group will be available from public sector banks, Regional rural banks, IDBI. In urban areas, 15% margin money subsidy for general group and 25% for special group will be available through KVIC. In rural areas, the margin money subsidy will be 25% to 35% respectively. Special group include SC / ST / OBC / Minority / Woman / Ex-servicemen / Physically Handicapped.

Eligibility:

i. Any individual, above 18 years of age

ii. For setting up of project costing above Rs.10 lakh in the manufacturing sector and above Rs. 5 lakh in the business/service sector, the beneficiaries should have at least VIII standard pass educational qualification.

iii. Assistance under the Scheme is available only for new projects sanctioned specifically under the PMEGP.

iv. Self Help Groups (including those belonging to BPL provided that they have not availed benefits under any other Scheme) are also eligible for assistance under PMEGP.

v. Institutions registered under Societies Registration Act, 1860;

vi. Production Co-operative Societies, and Charitable Trusts.

vii. Existing Units (under PMRY, REGP or any other scheme of Government of India or State Government) and the units that have already availed Government Subsidy under any other scheme of Government of India or State Government are not eligible.

Implementing Agencies:

In urban areas, the scheme will be implemented through DIC, while in rural areas through KVIC/KVIB/DIC all three agencies.

(B) Seed Money Scheme (SMS):

1. The objective of the scheme is to encourage unemployed person to take up self- employment ventures through industry, service and business, by providing soft loans to meet part of the margin money to avail institutional finance.

2. Eligibility:

Local unemployed person or group of persons fulfilling:

(a) Age Group: 18 to 50 years

(b) Qualification: Std. VII pass

(c) Domiciled in the state of Maharashtra for the last 15 years.

Scope:

i. Project cost upto Rs. 25 lakhs for industry, service and business activity.

ii. Seed Money assistance at 15 per cent of the project cost approved by financial institutions is offered. In case of projects costing up to Rs. 10 lakhs, the quantum of assistance ranges upto 15 per cent for General category and 20% for SC/ST and OBC/NT/VT/Handicapped upto 20 per cent.

iii. Seed Money component up to 3.75 lakhs maximum.

iv. Bank loan 75% of the project cost.

v. The rate of interest on seed money is 6% and if the borrower pays the repayment of installments regularly and within scheduled time, then the borrower will get rebate of 3% in interest. So he has to pay only 3% interest.

vi. If the installment is not repaid in time, it will attract 1% penal interest.

vii. The repayment of loan starts after three years in four yearly installments for industry cases. In other cases repayment starts after six months of loan availment.  

(C) District Industries Centre Loan Scheme (DIC Loan Scheme):

i. The objective of the scheme is to provide financial assistance in the form of margin/seed money for the promotion of tiny industries in semi-urban and rural areas with a view to generate employment opportunities including self-employment.

ii. Margin money assistance is admissible only to those units whose investment in plant & machinery does not exceed Rs.2 lacs.

iii. All towns and rural areas having population of less than 1 lac are covered under the Scheme.

iv. The extent of assistance is 20 % of the total investment or Rs. 40000/- whichever is less in case of entrepreneur belonging to general category and in case of entrepreneur belonging to scheduled caste & scheduled tribe, assistance upto 30 % of total fixed capital investment or upto maximum of Rs. 60000/- whichever is less is provided.

v. All units falling within the purview of the Small Scale Industries Board and Village Industries, handicrafts, handlooms, Silk & Coir Industries are covered under the Scheme.

vi. The State Government’s rate of interest on this loan is 4 % and repayment is to be done within 7 years.

vii. This scheme is particularly useful for rural artisans

At district level, these schemes are implemented by General Manager, District Industries Centre of respective district (PMEGP scheme is also implemented by KVIB & KVIC in rural areas). In Mumbai, PMEGP & Seed Money Scheme (excluding DIC loan scheme) is implemented by Joint Director of Industries, Mumbai Metropolitan Region, Mumbai.

So far as DIC/Joint Director of Industries, Mumbai Metropolitan Region, Mumbai is concerned, no collateral security is insisted. However, in case of Seed Money Scheme and District Industries Centre Loan Scheme, second charge is to be created on the assets created.

There is one scheme called Entrepreneurship Development and Training Programme which is implemented by Directorate of Industries through recognized Training Institutions such as MITCON Consultancy Services Ltd. and Maharashtra Centre for Entrepreneurship Development (MCED). Under this scheme, the aspects such as the Entrepreneurship Development and Technical Training are covered.

Some of the Indian Financial Institutions providing Project Finance are mentioned below:

i. North Eastern Development Finance Corporation Ltd.

ii. The Infrastructure Development Finance Company Limited (IDFC)

iii. Srei Infrastructure Finance Limited

iv. Infrastructure Leasing & Financial Services Limited (IL&FS)

v. Larsen and Toubro Infrastructure Finance Company Limited

vi. Industrial Finance Corporation of India (IFCI)

Project report is drafted as per the banking/financial institution norms on the basis of analyzed previous data and information provided by the client.

Documentation:

Some of the documents that are commonly required are:

1. Loan Agreement.

2. Deed of hypothecation.

3. Personal guarantee from main promoters, wherever required.

4. Undertaking from the promoters for:

i. Meeting overrun/shortfall in the project cost/means of financing

ii. Non-disposal of shareholdings by the promoters

5. Resolution under Section 293 of the Company’s Act.

If a project is analyzed from the different aspects of risk associated with the project, it will increase the likelihood of successful completion of the project with respect to cost, time and performance objectives. The financier can conduct qualitative as well as quantitative analysis of the project.

Qualitative analysis can be done in following ways:

(a) Interviewing key members of the project team

(b) Organizing brainstorming meetings with all interested parties

(c) By using the personal experience of the risk analyst

(d) Reviewing past corporate experience if appraisal records are kept

Once the qualitative analysis is done, the lender can perform quantitative analysis by using techniques like sensitivity analysis, decision trees, etc. The risk has to be quantified for basic project success criteria i.e. cost, time and performance. Once the project is financed, it has to be reviewed at different stages to ensure the time schedule and performance.

Project finance has been a domain of only Public Sector Banks with lot of documentation. But, nowadays, even private sector banks have started providing project finance with less documentation

Sometimes, the lender may ask the borrowing company for a stake in the share capital, in consideration for providing finance for the project. The borrower company should consider the dilution in control while opting for it. However, if the borrowing company opts for paying interest, it has to be careful and see that paying interest expenses does not lead to excessive outflow of cash. If used properly, project finance can help in the overall development of the business world.