Critically discuss the

potential financial risks

associated with projects and how to manage and/or mitigate the risks.

Project Financing

Learning Objectives

Evaluate the options available to finance a project

Explain the differences between Corporate Financing

and Project Financing

Explain the features of a Special Purpose Vehicle

(SPV) and how it is structured

Explain the benefits and risks associated with using a

SPV

What are the options available to

finance a new project?

Finance Options for Projects

Source of Finance

Same legal entity

Corporate Financing

â€¢

â€¢

Financed internally within the

company

Small projects

Separate legal entity

Project Financing

â€¢

â€¢

Special Purpose Vehicle (SPV)

Large-scale projects

Different Types of Funding

Equity

Debt

New share capital

Retained profits

New debt/

Loan capital

Ownership

Voting Rights

Growth

Dividends

Interest free

Dividend free

Interest payments

Capital repayments

Collateral security

What is Project Financing?

What is Project Financing?

There is no single definition of project finance.

the structured financing of a specific economic

entity â€” Special Purpose Vehicle (SPV) also

known as project company

created by project sponsors using equity and/or

debt

the lender considers being paid primarily by

the project cash flows.

Features of Project Financing

Long-term financing of an independent

capital investment

Non-recourse financing

Off-balance sheet financing

Why do sponsors use

Project Financing?

Differences between CF and PF

Corporate Financing

Project Financing

Financing vehicle

Multi-purpose organisation

Single-purpose entity

Type of capital

Permanent â€“ an indefinite

time horizon for equity

Finite time horizon matches

life of project

Basis for credit

evaluation

Focus on balance sheet and Focus on projectâ€™s assets,

cash flow

cash flow and contractual

arrangements

Guarantees for

financing

Assets of the borrower

Project assets

Accounting treatment

On balance sheet

Off-balance sheet

What is a Special Purpose Vehicle?

A separate legal entity (project company) with its

own assets/liabilities

Created by project sponsors using a mix of equity

and debt

For a special purpose (to finance a large project

and isolate the financial risk)

Special Purpose Vehicle

Project

Sponsor

Equity

Investors

Debt

Providers

Other

Sources

Special Purpose

Vehicle (SPV)

Project

Source: https://www.windpowerengineering.com/put-fence-around-project-finance-explained/

Special Purpose Vehicle

When are SPVs used?

SPVs are typically used to finance large-scale,

long-term projects e.g. infrastructure (roads,

railways), power generation (solar, wind, oil, gas)

by governments or large organisations.

Special Purpose Vehicle

How is a SPV structured?

Equity

Investors

Debt

Providers

Special Purpose

Vehicle (SPV)

Project

Special Purpose Vehicle

Capital Structure of SPV: a mix of debt and equity to

fund the project

Low Gearing: low debt + high equity

High Gearing: high debt + low equity

Equity

Â£200

Capital

Â£1,000

Equity

Â£800

Debt

Â£200

Capital

Â£1,000

Debt

Â£800

Special Purpose Vehicle

Gearing:

an indicator of how risky an investment in a

business might be.

There are many ways of calculating this.

ðƒðžð›ð

Ã— ðŸðŸŽðŸŽ%

ð„ðªð®ð¢ðð²+ðƒðžð›ð

or

ðƒðžð›ð

Ã— ðŸðŸŽðŸŽ%

ð„ðªð®ð¢ðð²

Special Purpose Vehicle

Equity

Debt

No interest payments or mandatory

fixed payments

Has interest payments (typically)

No maturity dates (no capital

repayment)

Has a fixed repayment schedule

Has ownership and a degree of

control over the business

Has first claim on the firmâ€™s assets in the

event of liquidation

Has voting rights (typically)

Expects a lower rate of return than

equity

Expects a high rate of return

(dividends and capital appreciation)

Prevents dilution of equity

Has last claim on the firmâ€™s assets in

the event of liquidation

Can push a company into bankruptcy

Special Purpose Vehicle

Benefits:

Isolation of financial risk

Access to wider capital markets

Undiluted ownership

Risks:

Complicated and expensive

Reputational risk

Regulatory risk

Enron Case Study

Enron Case Study

SPV = SPE (Special

Purpose Entity)

SEC = US Securities

and Exchange

Commission

FASB = US

Financial

Accounting

Standard Board

Project Risk Management

Learning Objectives

Understand the difference between Uncertainty

and Risk

Explain how a project evaluation is adjusted

under uncertainty and risk

Define project risk management and explain the

process for project risk management.

What is Project Risk?

An uncertain event or condition, that if it

occurs, has a positive or negative effect on

a projectâ€™s objective (PMBOK).

PMBOK: Project Management Body of Knowledge is a set of standard terminology and guidelines

for project management.

Risk vs Uncertainty

Risk vs Uncertainty

Risk can be applied to a situation where there are

several possible outcomes and on the basis of past

relevant experience, probabilities can be assigned to

the various outcomes that could prevail.

= Possible outcomes Ã— Expected probability (likelihood it will occur)

Uncertainty can be applied to a situation where there

are several possible outcomes but there is little past

relevant experience to enable the probability of the

possible outcomes to be predicted.

Risk vs Uncertainty

Project Evaluation

Uncertainty

â€¢

â€¢

â€¢

â€¢

Sensitivity analysis

Set a minimum payback period

Make prudent estimates of cash flows to

assess the worst possible situation

Assess both best and worst possible situations

to obtain a range of NPVs

Risk

â€¢

â€¢

Probability analysis

Simulation models

Investment Appraisal under Uncertainty and Risk

Payback period

Conservative forecasts

Range of NPVs

Sensitivity analysis

Probability analysis

Simulation

Sensitivity Analysis

Look at how much the initial assumptions have

to alter by to change the decision.

â€œwhat if?â€ questions, e.g. what if demand fell

by 10% compared to our original forecasts?

Would the project still be viable?

Sensitivity analysis assesses how responsive

the projectâ€™s NPV is to changes in the variables

used to calculate that NPV.

Sensitivity Analysis Formula

Sensitivity margin =

NPV

Ã— 100%

PV of variable under consideration

NPV could depend on a number of uncertain independent variables:

âœ“ selling price

âœ“ sales volume

âœ“ discount rate

âœ“ initial investment

âœ“ operating costs (variable costs, fixed costs)

âœ“ life of the project

Sensitivity Analysis

Example:

An investment of Â£40,000 today is expected to give rise to annual

contribution of Â£25,000 and annual fixed cost of Â£10,000 for the next four

years; the discount rate is 10%. The annual contribution of Â£25,000 is based

on selling one product, with a sales volume of 10,000 units, selling price of

Â£12.50 and variable costs of Â£10.

(a) Calculate NPV of this investment.

(b) Calculate the sensitivity of your calculation to the following:

(1) Initial investment

(2) contribution

(3) fixed costs

(4) variable costs

(5) sales volume

(6) selling price

Sensitivity Analysis

Solution:

(a)

Year

CF (Â£)

0

Investment

1â€“4

Sales

1â€“4

Variable costs

1â€“4

Fixed costs

DF@10%

NPV =

PV (Â£)

Sensitivity Analysis

Solution:

(b)

(1) Sensitivity to initial investment =

7,550

Ã— 100% = 18.9%

40,000

So an 18.9% increase in the cost of initial investment would cause

NPV to fall to zero.

(2) Sensitivity to contribution =

(3) Sensitivity to fixed costs =

(4) Sensitivity to variable costs =

Sensitivity Analysis

Solution:

(b)

(5) Sensitivity to sales volume =

(6) Sensitivity to selling price =

Sensitivity Analysis

â€¢ Advantages

– simple

– provides more information for management to make

judgements

– identifies critical estimates

â€¢ Disadvantages

– assumes variables change independently of each other

– only as good as the data on which forecasts are based

– does not assess the likelihood of a variable changing

Probability Analysis

Risk evaluation method to forecast the

likelihood of future events.

Probability distribution is the list of the

possible outcomes and their probabilities.

e.g. Pass module 80% (0.8), fail module 20% (0.2)

Probability Analysis

Expected Value (EV): is the weighted average

of all the possible outcomes, with the

weightings based on the probability

estimates.

It represents the long-run average outcome if

the decision were to be repeated many times.

Probability Analysis

Formula:

EV = Ïƒ ð‘ð‘¥

where

p = the probability of an outcome

x = the value of an outcome

Probability Analysis

Example:

Product ABC has the following probability distribution:

(1)

(2)

(3)

Outcomes

Estimated

Weighted amount

Â£

probability

Profits of Â£6,000

0.10

Profits of Â£7,000

0.30

Profits of Â£8,000

0.40

Profits of Â£9,000

0.20

1.00

Probability Analysis

Example:

(1)

Outcomes

Â£

Profits of Â£6,000

Profits of Â£7,000

Profits of Â£8,000

Profits of Â£9,000

(2)

Estimated

probability

0.10

0.30

0.40

0.20

1.00

(3)

Weighted amount

600

2,100

3,200

1,800

7,700

Expected Value

Expected value is the weighted average of the possible outcomes.

Probability Analysis

Advantages

– Takes account of risk (considers probability)

– Easy decision rule (answer is reduced to a single figure)

– Simple to calculate

Disadvantages

– Probabilities used are subjective

– The project may only be carried out once (one-off).

– Ignores attitude to risk

Probability Analysis

The simple EV decision rule is appropriate if:

â€“ there is a reasonable basis for making the forecasts and

estimating the probability of different outcomes;

– the decision is relatively small in relation to the business;

– the decision is for a category of decisions that are often

made.

EV technique is best suited to a problem which is

repetitive and involves relatively small investments.

Probability Analysis

Example:

A firm has to choose between three mutually exclusive projects, the

outcomes of which depend on the state of the economy. The following

estimates have been made:

State of economy

Recession

Stable

Growing

Probability

0.5

0.4

0.1

NPV (Â£000)

NPV

NPV

NPV

Project A

100

200

1,400

Project B

0

500

600

Project C

180

190

200

Determine which project should be selected on the basis of expected

market values.

Probability Analysis

Solution:

Project A

State of

economy

Probability

Project NPV

(Â£000)

EV

(Â£000)

Recession

0.5

100

50

Stable

0.4

200

80

Growing

0.1

1,400

140

270

Probability Analysis

Solution:

Project B

State of

economy

Probability

Recession

0.5

Stable

0.4

Growing

0.1

Project NPV

(Â£000)

EV

(Â£000)

Probability Analysis

Solution:

Project C

State of

economy

Probability

Recession

0.5

Stable

0.4

Growing

0.1

Project NPV

(Â£000)

EV

(Â£000)

Probability Analysis

Solution:

State of economy

Recession

Stable

Growing

Probability

0.5

0.4

0.1

NPV (Â£000)

NPV

NPV

NPV

Project A

100

200

1,400

Project B

0

500

600

Project C

180

190

200

EV

Simulation

Simulation is a modelling technique that shows the

effect of more than one variable changing at the same

time.

It involves the estimation of the probabilities of

different possible outcomes.

Sensitivity analysis: changing one variable at a time

Simulation analysis: many variables changing at the

same time.

Simulation

Advantages:

– includes all possible outcomes in the decision-making

process

– has a wide variety of applications.

Disadvantages:

– models can be very complex

– time and costs

– probability distributions may be difficult to formulate.

Project Risk Management

Project Risk Management

Project Risk Management is the process of

identifying, analysing and responding to

any risk that arises over the life cycle of a

project to help the project remain on track

and meet its objectives.

Project Risk Management

Identifying Potential Risks

To uncover, recognize and describe risks that might

affect the project or its outcomes.

Potential risks include the following:

â–ª

â–ª

â–ª

â–ª

â–ª

â–ª

â–ª

â–ª

â–ª

Technical

Cost

Schedule

Client

Weather

Financial

Political

Environmental

People

Assessing Risks

To determine the likelihood and consequence

of each risk.

Probability and Impact Matrix

â€¢ a tool for the project team to

analyse and evaluate risks.

â€¢ helps to determine which risks

need detailed risk response plans.

Controlling Risks

Risk Transfer

In some circumstances, risk can be transferred

wholly or in part to a third party, so if an adverse

event occurs, the third party suffers all or most of

the loss e.g. insurance.

Risk Avoidance

â–ª Risk can be avoided altogether.

â–ª Withdraw from the market / business /

geographic location

â–ª It is hard to avoid all risks.

Controlling Risks

Risk Reduction

Reducing the risk, which can be achieved by

limiting exposure to a particular business

area or attempting to decrease the adverse

effects should that risk occur.

Risk Acceptance

Accept that risk is part of business and have

a plan (strategy) to deal with it when it

happens.

Monitoring and Review

â€¢

â€¢

â€¢

â€¢

Identifying new risks and planning for them

Keeping track of existing risks to check if:

Reassessment of risks is necessary

Any of risk conditions have been triggered

Monitor any risks that could become more critical over

time

Tackle the remaining risks that require a longer-term,

planned, and managed approach with risk action plans

Purchase answer to see full

attachment