I) Why Project Finance
Firstly it is important to take into consideration the importance of growth and development for the major industries that maintain the economy of countries around the world, and for this matter the constant creation and renovation of infrastructure is totally necessary, in order to facilitate and accelerate the growth period of many industries driving each specific country.
The second reason that to choose Project Finance is due to the scope and the necessary means involved in making a successful venture in this type of activity:
Project Finance involves not only major capital investments, covered most of the time by different lenders or syndicate groups, but also ...view middle of the document...
Usually, the debt/equity ratio is around 80/20: the greater the debt proportion, the more return the investors will get. This is the principal of leverage: the asset will have a return higher than the debt’s interest rate and the difference will go to the shareholder. Investors that contribute to equity own the project, while debt only takes two different forms: loans and bonds.
There are many risks that can make project finance a very delicate activity. These include financial risks, environmental risks and political risks to mention a few, and as most of the activities of project finance concern big infrastructure projects the initial costs are very high while the returns can only be expected in the long term. Therefore it requires many different parties to be involved in order to spread this risk: equity investors (sponsors) and the bank. If the project in hand is a substantially large one, which obviously involves more risks, it would require a syndicated loan. This type of loan is given by a group of financial institutions.
b. Diagram of a Typical Project-Financed Deal
To summarize how Project Finance works, here is a diagram showing the links between the main players of such a project.
III) Challenges and Risk Management
Project finance projects face many common challenges and risks that can at any time can cause the project to fail. Let us first assess the main challenges of Project Finance and then study the main sources of risk (financial and non-financial) that can be encountered.
a. Main challenges and strategies
- The first challenge is the fact that the whole project’s capital (in 50% of the cases, more than $1 billion) is invested in one single-purpose asset, which creates risk from non-diversification.
- The second challenge comes from the two phases of the project, which are very different in terms of risks and cash flow patterns and therefore need different kinds of attention and risk management, as shown below: