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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
•
•
Financed internally within the
company
Small projects
Separate legal entity
Project Financing
•
•
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 — 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 – an indefinite
time horizon for equity
Finite time horizon matches
life of project
Basis for credit
evaluation
Focus on balance sheet and Focus on project’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
£200
Capital
£1,000
Equity
£800
Debt
£200
Capital
£1,000
Debt
£800
Special Purpose Vehicle
Gearing:
an indicator of how risky an investment in a
business might be.
There are many ways of calculating this.
𝐃𝐞𝐛𝐭
× 𝟏𝟎𝟎%
𝐄𝐪𝐮𝐢𝐭𝐲+𝐃𝐞𝐛𝐭
or
𝐃𝐞𝐛𝐭
× 𝟏𝟎𝟎%
𝐄𝐪𝐮𝐢𝐭𝐲
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 firm’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 firm’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 project’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 × 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
•
•
•
•
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
•
•
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.
“what if?” 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 project’s NPV is to changes in the variables
used to calculate that NPV.
Sensitivity Analysis Formula
Sensitivity margin =
NPV
× 100%
PV of variable under consideration
NPV could depend on a number of uncertain independent variables:
✓ selling price
✓ sales volume
✓ discount rate
✓ initial investment
✓ operating costs (variable costs, fixed costs)
✓ life of the project
Sensitivity Analysis
Example:
An investment of £40,000 today is expected to give rise to annual
contribution of £25,000 and annual fixed cost of £10,000 for the next four
years; the discount rate is 10%. The annual contribution of £25,000 is based
on selling one product, with a sales volume of 10,000 units, selling price of
£12.50 and variable costs of £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 (£)
0
Investment
1–4
Sales
1–4
Variable costs
1–4
Fixed costs
DF@10%
NPV =
PV (£)
Sensitivity Analysis
Solution:
(b)
(1) Sensitivity to initial investment =
7,550
× 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
• Advantages
– simple
– provides more information for management to make
judgements
– identifies critical estimates
• 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 = σ 𝑝𝑥
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
£
probability
Profits of £6,000
0.10
Profits of £7,000
0.30
Profits of £8,000
0.40
Profits of £9,000
0.20
1.00
Probability Analysis
Example:
(1)
Outcomes
£
Profits of £6,000
Profits of £7,000
Profits of £8,000
Profits of £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:
– 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 (£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
(£000)
EV
(£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
(£000)
EV
(£000)
Probability Analysis
Solution:
Project C
State of
economy
Probability
Recession
0.5
Stable
0.4
Growing
0.1
Project NPV
(£000)
EV
(£000)
Probability Analysis
Solution:
State of economy
Recession
Stable
Growing
Probability
0.5
0.4
0.1
NPV (£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
• a tool for the project team to
analyse and evaluate risks.
• 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
•
•
•
•
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

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