Long-Term Investments

Project Planning and Appraisal

Srinivasan Sundarasan

• Publisher: Routledge India
• Year: 2020
• Print ISBN: 9781138348387
• eBook ISBN: 9781000083842
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

First published in 2009. The limited text material available to highlight the relationships among capital structure, managerial incentives and valuation has also constrained teaching efforts at business schools. Long-term Investments is intended to give a bird's eye view of projects for a diverse audience encountered at contemporary business schools. This book is an attempt to blend the theory from Corporate Finance courses with the real-world situations encountered by a project analyst. It provides a systematic 'guided-tour' of the world of projects commencing with a strategic view, through the development of financial models and culminates with an evaluation of risk and the design of risk-mitigation measures. Given the emphasis on the development of financial models to help make investment decisions, it is designed to simultaneously appeal to business school students and to serve as a do-it-yourself guide for practicing professionals.

Chapter 1
Appraisal of Large-Scale Investment Projects: An Overview

KEY CHAPTER CONCEPTS

1. A project is a major undertaking with a predefined set of activities aimed at achieving a specified goal within a prescribed time horizon.
2. Project companies are constituted to mobilize and deploy resources to create and operate project-specific assets.
3. While there may not be a universal definition, projects involving US$ 100 million or more in investments and 15 years or more of anticipated useful lives, could be considered “large” in scale.
4. Investment decision making involves detailed investigations to ascertain the risks affecting the business transaction and putting appropriate mitigation measures in place.

GLOSSARY OF NEW TERMS

• Asset specificity transaction-specific, non-redeployable assets that are destined to perform unique tasks within the project.
• Debt Service payment of principal and interest on a loan
• Leverage the ratio of debt to total owners’ capital.
• Limited liability the liability of a firm’s investors limited to the capital invested.
• Non-recourse debt Debt that is serviced exclusively by the cash-flows emanating from the operations of the project company.
• Project Company A legal entity incorporated to undertake the tasks comprising the project.
• Risk contamination the phenomenon whereby a failing project imposes additional risks on an otherwise healthy sponsor.
• Sponsor (and collectively sponsors) the project’s equity owner(s).

Remaining Afloat: Project Decision Making Challenge

On January 12 2004, the Queen Mary 2 (QM2) set sail on her maiden voyage from Southampton, England to Fort Lauderdale, Florida in the United States, carrying 2,620 passengers. The QM2 is undoubtedly the most magnificent ocean liner ever built, studded with opulent public areas, lavishly appointed dining rooms, ballrooms, theatres, lounges, kennels and the one of a kind planetarium at sea.

Ocean liner company, Cunard*, have put their experience from over a century and a half to good use in concocting a singular blend of the old-world charm of seafaring with exalted luxury to serve the world’s elite, ranging from royalty and statesmen to rock artists and film stars. The US$800m ocean liner, specifically designed for the challenging transatlantic routes required 40% more steel than a comparable cruise liner, and a power plant capable of propelling the ship at about 30 knots, considered essential to wean traffic away from modern day super jumbos. At a capacity of about 2,600 guests, the capital cost of constructing the ocean liner is estimated at US$300,000 per berth: twice the previous benchmark for cruise ships.

* www.cunard.com;

Everything about the QM2 is spectacular, including the crew size of 1253 personnel. In fact, Cunard has consciously decided not to restrict her size to PANAMAX standards – the largest ship dimension passing through the Panama Canal, and as she is too large to dock in most ports, passengers are ferried to and from the ship.

The Queen Mary 2 is a product of meticulous appraisal and conscious financial decision making. Decisions such as the commissioning of the QM2 project affect the risk of the firm and the success of the firm in maximizing shareholder wealth. Among the key concerns for decision makers are:

• Cash-flow considerations – optimizing revenues from operations to justify the first cost, recover the operational expenditure and to earn respectable returns for shareholders within an acceptable timeframe.
• Capital structure decisions – mobilizing investment resources and appropriately sizing the debt and equity components in keeping with the cashflow patterns for the project.
• Risk assessment and mitigation – estimating and minimizing the uncertainty associated with future cashflows at least cost.

The financial concepts and tools needed to deal with such concerns in various settings, and to help make more effective decisions are the subject matter of this book. Given the huge demand for investments, especially into infrastructure projects in several developing countries, investors, finance managers, lawyers, consultants, and officials involved in rolling out, operating and regulating such projects need to be adequately equipped to structure transactions so as to maximise value and minimise risk of failure.

Introduction

A project* is typically a major undertaking contemplated as comprising a unique set of predefined tasks, intended to achieve a preset goal within a prescribed time horizon.

* Literally: something thrown forward: derived from Latin pro - “forward” and jacere - “to throw”, Harper, (2001), Online Etymology Dictionary, http://dictionary.reference.com/browse/project.

A project normally involves the setup of a legally independent, limited liability project company, with its own management structure, personnel and corporate governance systems. The project company raises equity capital from one or more sources and supplements it with non-recourse debt for creation of specified capital assets. Project finance is, essentially, the process of allocating project risk to the entities that are most suited to managing them. Most projects involve large upfront capital costs and very low operating costs relative to the upfront costs. In other words, typical project investments have a “time profile”, that is, most of the costs are borne up-front, while benefits from the project are derived with a delay. Additionally, most project companies have few investment opportunities for the free cash generated. The most common applications of project finance are in resource extraction and infrastructure sectors.

The Project Company

Project Financing is the process of mobilizing funding for large capital-intensive projects, inter alia, involving the creation of project specific assets with finite lives to be owned and managed by the project company. A project company typically has few—often in the order of three — sponsors, who then approach lenders to mobilize project debt. A limited liability project company avoids risk contamination i.e., insulates the sponsoring parent in the event of the project’s failure.

The creation of a legally distinct entity to acquire, own and operate the assets created for the project imparts focus. The expenditure incurred by the project company is readily mapped on to investments flowing in, enhancing transparency in cash-flows and hence superior oversight of free-cashflow management.

A legal entity with a distinct physical location is also suited to effect the installation of a custom-designed management structure, tailored to deliver on the project’s objectives. Issues relating to corporate governance, information sharing and expeditious decision making are better addressed and resolved within the framework of a project company.

Non-recourse Debt

The most distinctive feature of project finance is the lenders’ exclusive dependence on the project’s cash flows to service the project company’s debt. In project parlance, the term “Project Finance” is frequently used to synonymously with non-recourse debt. As a natural extension of this feature, the lenders also rely solely on the project assets as security against the loan. In the event of default, the lenders could choose to enforce th...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Contents
• Preface
• 1. Appraisal of Large-Scale Investment Projects: An Overview
• 2. Strategic Aspects of Large-scale Investment Projects
• 3. Financial Modeling
• 4. Optimization of Capital Structure
• 5. Assessment of Project Viability
• 6. Analysis of Project Risk
• 7. Management of Project Risk
• 8. Risk and Real Options in Project Appraisal
• 9. Public Private Partnerships and the Role of Governments
• Appendix A
• Annexures
• Index