Advantages and Disadvantages of Project Finance

What is project finance?

Project financing is the process of providing funds for a particular project, frequently one involving construction or finance, in which the creditors rely on working capital and project revenues to recover their initial investments.

Essentially, this means that the investor understands the financial flows and recognizes that the only way to pay off debts is by generating profits. In other words, project investments are meant to ensure that the project funds itself, and consequently, they constitute the sole guarantee of project completion.

Now let’s get straight to the point and explain the advantages and disadvantages of project financing.

Advantages of project financing

Effective Allocation of Debt

With the aid of project financing, sponsors can borrow money over and above what their parents can afford. This loan can serve as a standalone transaction. It remains unaffected by the creditworthiness of its sponsors. Therefore, depending entirely on the value and possibilities of the project, more advantageous and flexible loan conditions can be negotiated.

Management of Risk

As was already said, the segregation of the parents’ and SPV’s legal identities is what genuinely distinguishes project finance. This vastly increases diversity and dilutes the risk factor. The parent company’s stockholders are shielded from changes in the project’s outcome. The sponsors’ equity contribution is the maximum amount for which they are liable. The danger is also decreased when many companies are involved. It is common for many businesses to join together to create a single SPV. As a result, the same level of risk decreases when more parties share it, reducing each party’s exposure.

large-scale economies

An SPV will almost certainly exhibit economies of scale when launched by many parents. Only when two modern businesses can clearly understand how their alliance would benefit them will they agree to work together toward a similar objective. One organisation might significantly gain at the cost of the other, and vice versa, especially in the construction and manufacturing industries.

For the sale of extracted material, for instance, a mining business and an extraction company could agree to work together. There will be some vertical synergies. The scale and earnings that both organisations can achieve are ones that neither could have achieved on their own. They will also be able to negotiate more favourably with both buyers and sellers.

Disadvantages of Project Financing

Sophistication

A step up from a straightforward credit transaction is project financing. Several parties have built it through a series of contracts, each of which involved difficult discussions. If adequate discretion is not used, it may be challenging to keep track of the money’s transfer among the parties concerned. Additionally, an imagined entity (SPV) routes all transactions. As a result, it is crucial to have specialised resources that constantly keep an eye on the flow of transactions.

Documentation and Conformity

A special-purpose vehicle (SPV) must be set up, which is a laborious, costly, and time-consuming operation. Before giving the SPV any credit at all, banks and other financial institutions carry out extensive research and inspections. An SPV’s sponsors bear the burden of this agonizing procedure because they must be doubly certain of the company’s stability and prospects for the future.

A project finance initiative also attracts the government’s attention. When approving the formation of an SPV, the government is very cautious. This is because many newly formed parallel groups have a history of engaging in egregious violations of laws, including tax evasion, money laundering, and rule-breaking. Therefore, to earn its confidence, a prospective SPV must be diligent and adhere to all requirements.

Constant Professional Support

Project financing involves complex transactions and requires the participation of several stakeholders. As a result, using the services of specialists and experts is necessary. It costs a lot to set up a powerful model for getting credit and running a firm. This expense might be compared to the extravagant and expensive fees that bankers and other specialists get to facilitate project financing.

Conclusion

In project finance, constraints limit the recourse of the lenders. As a result, in the scenario of a default, the creditors will have access to the project’s assets to secure its execution and enforce performance obligations.

In contrast to recourse finance, where the lenders have a complete claim to the customer’s assets or cash flows, project financing does not do so. Consequently, project finance requires individuals with good financial and pertinent technical expertise.

About Finline!

Finline is an online platform for creating financial reports for getting bank loans and investments. It’s like ‘Canva’ but for financials. If you are an entrepreneur looking for a bank loan, you need to have a well-crafted project report. We, at Finline help you with that. Our team will help you create a powerful business plan in ten minutes. That too in your language. Our reports are accepted by all public and private sector banks working in India. Click to create your report.

Project Finance and Corporate Finance

Project Finance and Corporate Finance are also referred to as Balance Sheet Financing. There are two financing models to fulfil the requirements of a business, both rely on debt and equity as sources of funds.

What is Corporate Finance?

The objective of the Corporate Finance model is to ensure the optimal usage of the available capital and maximize the shareholders’ wealth. Corporate Finance is the financing model, to puts all its projects/ business segments under one roof and consolidates the cash flows.

The Corporate Finance model actively shares the risks and rewards associated with the respective projects/segments. It particularly helps the entities having various projects with a similar risk profile. The success or failure of these projects affects the corporate balance sheet directly.

If the lenders experience a payment default, they can lay claim to company assets since they serve as collateral. The security offered to the lenders is generally common. On all the assets and cash flows of the business entity.

Similarly, a company that might need to reorganize following a bankruptcy filing could use corporate finance to gain access to capital or reorganize debt. Corporate executives also use this type of financing to add value for shareholders by improving operations and ultimately generating greater profits.

What is Project Finance?

Lenders offer project financing as a long-term, zero, or limited recourse financing solution to borrowers based on the rights, assets, and interests associated with the relevant project. As this scheme offers financial aid off the balance sheet, it does not affect the credit of the Government contracting authority or the shareholders. Since Project Financing shifts part of the risk associated with the project to the lenders, this financial plan is one of the most preferred options for private-sector companies.

With Project Financing, a company can arrange for a loan based on the cash flow generated at the end of a project while using the assets, rights, and interests of the concerned project as collateral. Whether it’s a long-term infrastructure project, public services initiative, or industrial endeavour, securing funds for the implementation and successful operation of the undertaking is a fundamental aspect of the entire process.

The repayment of this loan can be done using the cash flow generated once the project is complete instead of the balance sheets of the sponsors. If the borrower fails to comply with the terms of the loan, the lender has the right to take control of the project.

Key Features of Project Financing

Below mentioned are the key features of Project Financing:

Capital Intensive Financing Scheme: Project Financing is ideal for ventures requiring a huge amount of equity and debt, and is usually implemented in developing countries as it leads to the economic growth of the country. To ensure the project is against these risks, the project also has to pay expensive premiums.
Risk Allocation: Risks associated with the project are shifted towards the lender. Therefore, sponsors prefer to avail this financing scheme since it helps them mitigate some of the risks. On the other hand, lenders can receive a better credit margin with Project Financing.
Multiple Participants Applicable: As Project Financing often concerns a large-scale project, it is possible to allocate numerous parties to the project to take care of its various aspects.
Asset Ownership is Decided After Project: Once the project is completed, the project ownership goes to the concerned entity as determined by the terms of the loan.
Zero or Limited Recourse Financing Solution: The financial services company can opt for limited recourse from the sponsors if it deduces that the project might not be able to generate enough cash flow to repay the loan after completion.
Loan Repayment With Project Cash Flow: In Project Financing, the excess cash flow received by the project should be used to pay off the outstanding debt received by the borrower. Gradually paying off the debt will reduce the risk exposure of financial services companies.
Better Tax Treatment: The project /or the sponsors can receive the benefit of better tax treatment. Therefore, this financing solution is the preference of sponsors to receive funds for long-term projects.
Sponsor Credit Has No Impact on Project: While this long-term financing plan maximizes the leverage of a project, it also ensures that the credit standings of the sponsor have no negative impact on the project

Conclusion

Investors use project financing, a long-term, non-recourse, or limited recourse financing scheme, to fund massive projects. After completing the project, we use the project cash flow for repayment. This scheme offers financial aid off-balance sheet. Therefore, the credit of the shareholder and Government contracting authority does not get affected. This financial scheme offers a better credit margin to lenders while shifting some of the risk from the sponsors to the lenders.

About Finline!

Finline is an online platform for creating financial reports for getting bank loans and investments. It’s like ‘Canva’ but for financials. If you are an entrepreneur looking for a bank loan, you must have a well-crafted project report. We, at Finline will help you with that. Our team will help you create a powerful business plan in ten minutes. That too in your language. All public and private sector banks working in India accept our project report. Click to create your report.