Project Finance Ava

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PROJECT FINANCE

AROLKAR ABHAY VASANTPartner,

M/s A.V.Arolkar & Co., Chartered Accountants

MUMBAI

April 28, 2012 1A. V. Arolkar & Co., Chartered Accountants


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INTRODUCTION

With a view to harnessing advancements in

economic development, GoI laid emphasis on

industrialisation through successive Five Year

Plans.

Rapid industrial development needed massive

investment.

Prior to independence, there were no

institutional arrangements for term finance.



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INTRODUCTION

GoI, therefore, established the following

financial institutions:

Indl. Finance Corporation of India (1948) Indl. Credit & Inv. Corpn. of India (1955)

Indl. Development Bank of India (1964) &

Indl. Reconstruction Bank of India (1971)

Similarly, State Governments also established

SFCs in their respective states.April 28, 2012 3A. V. Arolkar & Co., Chartered Accountants


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INTRODUCTION

For long, commercial banks confined their

lendings to meet WC requirements only and

they did not play any active role in extending

term finance.

However, with increasing proportion of Term

Deposits in their deposit portfolio and the

paucity of resources in the country, it was felt

that banks could enter the field of term

finance, in a role complementary to that of

Term Lending Institutions.April 28, 2012 4A. V. Arolkar & Co., Chartered Accountants


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PROJECT BACKGROUND

The purpose of term assistance is to meet a

part of the capital expenditure of a project.

A project can be defined as A scheme ofthings to be done during a specified period in

future for deriving expected benefits under

certain assumed conditions.

A project may be in the nature of setting up a

new industrial unit, modernisation, expansion,

diversification and promotion of R&D.April 28, 2012 5A. V. Arolkar & Co., Chartered Accountants


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PROJECT BACKGROUND

To set up a project, certain capitalexpenditure needs to be incurred in acquiringassets such as L&B, P&M and otherinfrastructural facilities like roads, watersupply, railway sidings, etc., in addition to thePreliminary / Pre-Operative Expenses andmargin on WC Limits.

Where promoters of a project are unable tomeet the entire capital expenditure out oftheir own resources, Term Loans are

sanctioned to supplement the promoterscontribution.April 28, 2012 6A. V. Arolkar & Co., Chartered Accountants


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PROJECT BACKGROUND

Promoters of an industrial project can

constitute themselves into any of the

following forms of business organisations to

implement the project : Sole Proprietorship,JHF, Partnership, Co-operative Society & Joint

Stock Company.

Our discussion of the subject would revolve

around Joint Stock Company as promoter.



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PROJECT BACKGROUND

The Promotion Stage is a crucial stage in the

entire life cycle of a project. Promotion in

relation to a project will comprise broadly the

following functions:

I] Identification of a project

II] Feasibility investigation

III] Assembling the proposition

IV] Financing the propositionApril 28, 2012 8A. V. Arolkar & Co., Chartered Accountants


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I] Identification of a Project

The first step in the project promotion is the

identification of a project. An industrial

project originates as an idea in a promoter

when he observes the existence of a potentialmarket for a certain product.

The promoter, on the basis of his experience,

background and ability, then considers the

feasibility of manufacturing and marketing the

product at a remunerative price.



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II] Feasibility Investigation

A detailed feasibility study is a costly exercise.It is, therefore, desirable that, before it is

undertaken, marketability of the product to

be manufactured is firmly established.

There are agencies, specialising in market

research, which conduct such market studies.

Promoters may take advantage of theirservices.

A market study aims at assessing the

aggregate demand for a product.April 28, 2012 10A. V. Arolkar & Co., Chartered Accountants


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The promoter will now undertake the detailed

feasibility investigation proper, comprising

two feasibility studies:

i) The Technical Feasibility Study

ii) The Economic Feasibility Study



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- Technical Feasibility

Technical Feasibility Study covers thefollowing aspects:

Location of the project

Lay-out of the PlantSize of the Plant

Factory construction

Manufacturing process / TechnologyProcess Design

Product Design

Scale of Operation

Infrastructural facilitiesApril 28, 2012 12A. V. Arolkar & Co., Chartered Accountants


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- Economic Feasibility

The prime objective of setting up a project is

to derive a fair return on the investment.

Economic Feasibility Study, therefore,concerns itself with matching of economic

resources with the physical requirements of a

project and determining the viability of

investment therein.



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III] Assembling the Proposition

- CoP & MoF

When a promoter is satisfied about thetechnical feasibility and economic viability ofa project, the next task is to work out the

Cost of the Project and the Means of financingit.

The Cost of the Project would broadly include:

(a) L&B (b) P&M (c) Misc. Fixed Assets (d)Technical Know-how, Engg. & Consultancyfees (e) Preliminary and Pre-operativeexpenses (f) Provision for contingencies (g)

Margin on WC LimitsApril 28, 2012 14A. V. Arolkar & Co., Chartered Accountants


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IV] Financing the Proposition

Setting up of a project involves acquisition ofFixed Assets which facilitate the process ofproduction. Fixed Assets have a relatively

longer life and are generally not meant forresale. They are required to be retained overa period of time to exploit their productivepotential.

C/A go through the operating cycle of RM, WIPand FG, which when sold bring in cash. Thiscycle is generally completed in a short period

of less than one year.April 28, 2012 15A. V. Arolkar & Co., Chartered Accountants


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Thus, investment in C/A is realised over a

short term, while investment in Fixed Assets is

long term in nature.

It is realised through surplus generated in the

form of Net Profits, Depreciation and other

non-cash write-offs.

As it takes a long time for the Fixed Assets to

pay for themselves, the promoter should raise

suitable long term funds to finance a project.April 28, 2012 16A. V. Arolkar & Co., Chartered Accountants


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Keeping the foregoing in view, the promoter

will explore the financial feasibility of the

project by examining

a) The possible long term sources of finance

b) The feasible financial leverage

c) The expected return on the investment



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Equity Preference

Share Capital Retained Earnings

OWNED CAPITAL

Debentures Term Loans, DPGs Public Deposits

BORROWED CAPITAL

LONG TERM SOURCES



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- Long Term Sources

The aggregate amount of finance raised for

financing a project is referred to as Capital,

comprising two components (a) Owned

Capital and (b) Borrowed Capital.

The other sources of long term funds are:

(a) Capital Subsidy applicable to projects

coming up in certain notified backward areas,

and (b) Interest free sales tax loans offered by

State Governments.



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- Financial Leverage

After considering availability of long terms

sources of finance, the promoter will decide

about a suitable financial structure for the

Company.

It will depend upon the financial leverage

envisaged in the combination of sources of

finance under the two categories, viz., Owned

Capital and Borrowed Capital.

Few projects can be financed entirely byApril 28, 2012 20A. V. Arolkar & Co., Chartered Accountants


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- Financial Leverage

The divergent interests of debt and equity are

brought into alignment by the concept of Debt

/ Equity gearing which determines the level of

debt that can be supported by a givenquantum of equity.

For this purpose, Debt means Funded Debt

including all term liabilities and equity will

include Share Capital and retained earnings, if

available.




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IV] Financing the Proposition- Return on Investment

The amount invested in a project can be

recouped through annual cash flows, over a

period of time.

In arriving at a financial plan for the project, a

promoter will examine the attractiveness of

the project, vis--vis alternative sources ofinvestment.

The process which assists the management in

such a task is collectively known as CapitalApril 28, 2012 22A. V. Arolkar & Co., Chartered Accountants


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- Return on Investment

The most important and widely used Capital

Investment Evaluation techniques are:

Pay-back MethodNet Terminal Surplus Method

Excess Present Value Method

Internal Rate of Return Method



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The object of Pay-back Method is to find out

the period of time required for recovering the

entire amount of investment made in a

project.

The cash flows (Net Profit + Depreciation +

Other non-cash write-offs) are compared with

the outlay on the project to determine the

pay-back period. Years to pay back would be:

Total InvestmentApril 28, 2012 24A. V. Arolkar & Co., Chartered Accountants


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Net Terminal Surplus Method employs the

concept of compounding which involves

re-investing the simple interest earned each

year along with the principal so that theprincipal grows each year by the amount of

interest earned during the previous year and

interest being calculated on the increasedprincipal also grows.

Future Value = Principal x (1+i)


] h


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Excess Present Value Method is based on thediscounted cash flow technique and uses the conceptof discounting which is just the opposite ofcompounding.

In discounting, we arrive at the Present value of afuture sum to which the original amount (which wewant to find out), invested at a particular compound

rate of interest has grown.PV = Future sum

(1+i)


IV] Fi i h P i i


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Internal Rate of Return Method It is that rate at

which the sum of the discounted cash flows is equal

to the investment outlay. In other words, IRR is the

rate which makes the Present Value (PV) of benefitsequal to the Present Value of costs or reduces the

Net Present Value (NPV) to zero. The object of this

method is to find the rate of return which a project

is likely to earn over its useful life.

IRR =Lower Discount Rate + Diff. Between the two discount rates x NPV at lower discount rateAbs. diff. between the two NPVs.



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Types of Term Assistance

The types of term assistance extended by the

Bank can be broadly classified into:

I] Term Loans (Incl. Forex Loans)

II] Deferred Payment Guarantees

III] Bill Discounting Facilities

IV] Underwriting of Shares / Debentures


T f T A i


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-Term Loan

A Term Loan is a loan granted for a fixed term

of not less than one year, intended normally

for financing fixed assets acquired / to be

acquired, carrying interest at a specified rate,and scheduled for repayment in instalments.

Depending on the term for which the said

terms loans are granted, they could be

classified into (a) Short Term Loans (b)

Medium Term Loans and (c) Long Term Loans.


T f T A i t


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-DPG

Deferred Payment Guarantee (DPG) is a contract topay to the supplier the price of machinery, suppliedby him on deferred terms, in agreed instalments withstipulated interest on the respective due dates in

case of default in payment thereof by the buyer.

A DPG is, in many respects, a substitute for a TermLoan and, as far as the buyer of P&M is concerned, it

serves the same purposes as a Term Loan. Standards of appraisal are the same as TL.


T f T A i t


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- Bills Discounting

Under a contract for sale of machinery on

deferred payment basis, the balance

remaining to be paid after the initial down

payment represents the deferred receivablesof the seller.

Thus, the funds of the seller get blocked for

unduly long periods and the seller requires

finance against such deferred receivables to

replenish his Working Capital.


T f T A i t


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- Bills Discounting

To facilitate availment of finance against the

deferred receivables, the seller usually draws

a series of usance bills with graded maturities

to coincide with the due dates of payment ofthe relative instalments (including applicable

interest).

The usance bills drawn by the seller will be

accepted by the buyer before they are

discounted by the sellers banker.


T f T A i t


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- Underwriting of Shares

The necessity for underwriting arrangementarises only in the case of a Public LimitedCompany resorting to raise through the capital

issue market, a part of the Share Capital forpart-financing a project.

Underwriting is a contract whereby a person

agrees, in consideration, to take up aspecified number of shares or debentures oramount of debenture stock to be offered tothe public, in the event of the public not

subscribing for them.April 28, 2012 33A. V. Arolkar & Co., Chartered Accountants

T f T A i t


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- Underwriting of Shares

Underwriting as a business will come under the scope of

Investment Banking as distinct from Commercial

Banking.

In view of this, therefore, a high degree of selectivityshould continue to be exercised in undertaking

underwriting business.

However, the business stemmed not so much from the

point of view of earnings on the investment as from the

consideration that no viable project enjoying national

priority should suffer for want of underwriting support.



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Project Appraisal

The purpose of Project Appraisal is to ascertainwhether the project will be sound technically,economically, financially and managerially andultimately viable as a commercial proposition.

The appraisal of a project will involve theexamination of:

a) Technical Feasibility : To determine the suitability

of the technology selected and the adequacy of thetechnical investigation, and design.



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Project Appraisal

b) Economic Feasibility : To determine theconduciveness of economic parameters to setting upthe project and their impact on the scale ofoperations.

c) Financial Feasibility : To determine the accuracyof cost estimates, suitability of the envisaged patternof financing and general soundness of the capital

structure. d) Commercial Viability : To ascertain the extent of

profitability of the project and its sufficiency inrelation to the repayment obligations pertaining to

term finance.April 28, 2012 36A. V. Arolkar & Co., Chartered Accountants


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Project Appraisal

e) Managerial Competency : To ascertain thatcompetent men are behind the project toensure its successful implementation and

efficient management after commencement ofcommercial production.

A project should also be examined, wherever

appropriate, from the point of view of itsvalue to the national economy in terms ofsocio-economic benefits like generation ofemployment opportunities, forex earnings, the

quantum of import substitution, etc.April 28, 2012 37A. V. Arolkar & Co., Chartered Accountants


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Project Appraisal

The first step in Project Appraisal is to find out

whether the project is prima facie acceptable byexamining salient features such as:

The background and experience of the applicants,particularly in the proposed line of activity

The potential demand for the product

The availability of the required inputs, utilities andother infrastructural facilities

Whether the project is in keeping with the priorities,

if any, laid down by the Government.April 28, 2012 38A. V. Arolkar & Co., Chartered Accountants


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Project Appraisal

The original application may not contain all the basicdata / information. In such cases, it may benecessary to provide all the necessary data /information with a view to give an overall idea aboutthe general feasibility of the project at the time ofinterview by the bankers.

After satisfying itself about the prima facie

acceptability of the project, the Bankers will call foran prescribed Application, containing the followingessential data / information, such as:



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Project Appraisal

a) Particulars of the project along with a copy

of the Project Report furnishing details of the

technology, manufacturing process,

availability of construction / productionfacilities, etc.

b) Estimates of cost of the project detailing

the itemised assets acquired / to be acquired,

inclusive of Preliminary / Pre-operative

Expenses and WC margin requirements.April 28, 2012 40A. V. Arolkar & Co., Chartered Accountants


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Project Appraisal

c) Details of the proposed means of financingindicating the extent ofpromoters contribution, thequantum of Share Capital to be raised by publicissue, the composition of the borrowed capitalportion with particulars of Term Loans, DPGs, ForeignCurrency Loans, etc.

d) WC requirements at the peak level (i.e., when the

level of Gross Current Assets is at the peak) duringthe first year of operations after the commencementof commercial production and the bankingarrangements to be made for financing the WC

requirements.April 28, 2012 41A. V. Arolkar & Co., Chartered Accountants


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Project Appraisal

e) Project Implementation Schedule.

f) Organisational set up along with a list ofBoard of Directors and indicating thequalifications, experience and competence of(i) The key personnel to be in charge ofimplementation of the project during the

construction period and (ii) The executives tobe in charge of the functional areas ofpurchase, production, marketing and financeafter commencement of commercial

production.April 28, 2012 42A. V. Arolkar & Co., Chartered Accountants


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Project Appraisal

g) Demand projection based on the overall

market prospects together with a copy of the

market survey report.

h) Estimates of sales, CoP and profitability.

i) Projected P&L Account and B/S for the

operating years during the currency of theBanks term assistance.

j) Proposed amortisation schedule, i.e.,

repayment programme.April 28, 2012 43A. V. Arolkar & Co., Chartered Accountants


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Project Appraisal

k) Projected Funds Flow Statement covering

both the construction period and the

subsequent operating years during the

currency of the Term Loan.

l) Details of the nature and value of the

securities offered.

m) Consents from the Government / other

authorities and any other relevant

information.April 28, 2012 44A. V. Arolkar & Co., Chartered Accountants


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Project Appraisal

In respect of existing concerns, in addition to

this information, particulars regarding the

history of the concern, its past performance,

present financial position, etc., should also becalled for.

The Application completed in all respects

and duly signed by the authorised signatories

of the Company will form the basis for the

detailed appraisal of the project.April 28, 2012 45A. V. Arolkar & Co., Chartered Accountants


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Project Appraisal

An inspection of the project site (or factory in thecase of existing units) will be done by the bankers.

Each project has to be examined in proper

perspective having due regard to its nature, size andscope.

Although the basic techniques employed forappraising the viability of various projects are moreor less the same, there could be no standard oruniform approach for appraising all projects.



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Project Appraisal

The ultimate objective of the appraisal

exercise is to ascertain the viability of a

project with a view to ensuring the repayment

of the borrowers obligations under the Banksterm assistance.

Therefore, it is not so much the quantum of

the proposed term assistance as the prospects

of its repayment that weighs with the bankers

while appraising a project.April 28, 2012 47A. V. Arolkar & Co., Chartered Accountants


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Project Appraisal

In project appraisal, nothing is assumed or taken for

granted, so be truthful and give facts

All the data / information would be checked and,

wherever possible, counter-checked through inter-

firm and inter-industry comparisons.

It should be borne in mind that bankers believe

Healthy scepticism is a cardinal virtue in projectappraisal.



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Project Appraisal Memorandum

1. PROPOSAL

Nature of proposal;

Purpose : New project, expansion, modernisation, diversification or for any other approved purpose

2. BRIEF HISTORY

Brief account of corporate history; MA & AA; Regd. address; Present organisational set up with BoD; Qualifications, experience and background;

Line of activities, Financial position, etc., of Associate Concerns; Overall structure of inter-corporate investments

3. PAST PERFORMANCESummary of Company's past performance in terms of licensed / installed / operating capacities, sales, operating profit and Net Profit for

the past 3 years; Capacity utilisation; Sales & profitability; Dividend policy; Capital expenditure programmes implemented by the Company

during the past 3 years and how they were financed; Company's management-labour relations

4. PRESENT FINANCIAL POSITION

Company's audited Balance Sheets & P/L Accounts for the past 3 years with analysis; Company's Capital structure; Summarise conclusions

of financial analysis; Method of depreciation; Revaluation of F/A; Record of major defaults; Position of Company's tax assessment; ContingentLiabilities; Pending suits; Qualifications / Adverse remarks by auditors

PROJECT APPRAISAL MEMORANDUM

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5. PROJECT

(a) Description of the project (Modernisation, expansion, diversification or a new venture) ; Standing, experience and reliability of

outside agency who prepared the Project Report; (b) Collaboration Arrangement (Technical or Financial); (c) Technical Feasibility covering

suitability of technology, size & location of plant, technical arrangements & mfg. process (d) Financial Feasibility covering Cost of Project & Means of Finance

6. PROJECT IMPLEMENTATION SCHEDULE

With reference to Bar Chart or PERT / CPM Chart and in the light of actual implementation; Main stages in the project implementation and whether the time

schedule for construction, erection / installation of P&M, start-up / trial run, commencement of commercial production is reasonable & acceptable

7. PRODUCTION FACTORS

(a) Mfg. Process - Basis of selection & justification; (b) Raw Materials - Imported / Indigenous, Names of main suppliers, Pattern of unit prices & fluctuation;

(c) Utilities & Essential Services - Requirements of power, fuel, water, transport, railway siding with comments on adequacy of arrangements, treatment

and disposal of effluents; (d) Operating Organisation - Experience and expertise of Managerial / Technical personnel, other staff required

8. WORKING CAPITAL REQUIREMENTS

Assessment of total WC requirements at the peak level (GCA) during the first year of operations after commencement of commercial production;

sharing of business among member banks; financing of additional WC requirments in case of existing companies


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9. MARKETING

(a) Sales prospects and underlying assumptions, demand projections on the basis of past consumption, total supply position, general condition of industry

(b) Selling Price - Trend to see whether stable, Govt. price controls, quota systems, etc.; (c) Propsects for exports - Export obligations;

(d) Marketing Organisation - Adequacy, Distributors / Selling Agents, Terms of arrangement, remuneration, competence, Asso. Concerns - Siphoning of profits

10. COMMERCIAL VIABILITY - CoP & PROFITABILITY

(A) Sales Volume / Value - (a) Volume; (b) No. of working days; (c) Capacity utilisation; (d) Value (B) CoP - (a) Matls. consumed; (b) Utilities (PW&F); (c) Wages & Salaries

(d) Factory Overheads; (e) Depreciation - SLM / WDV- Consistency; (f) Selling Exp.; (g) Financial Exp.; (h) Admn. Exp.; (i) Royalty & Know-how; (j) Preliminary / Pre-operative

Exp.; (k) Taxation (C) Profitability (CMA Data and ratios) (D) Inter-firm comparison

11. COMMERCIAL VIABILITY - DSCR & REPAYMENT PROGRAMME(a) DSCR (Gross) and (Net) ['Core Test' Ratio], Margin of safety and extent of risk coverage; (b) Break-Even Analysis - For first full year of production and

the year of maximum capacity utilisation; (c) Cost-Volume-Price (CVP) or Senstivity Analysis - For the year with operating profit nearest to the average operating profit to

determine 'Span of Resiliency' of the project; (d) Repayment Programme based on the above factors and initial moratorium (start-up) period

12. FUNDS FLOW ANALYSIS

Funds Flows to be divided into Long Term Funds Flows and Short Term Funds Flows - Dif. would indicate Long Term Surplus or Deficit / Movements in C/A & OCL leading to

increase or decrease in WCG; Essential expenditure on F/A, repayment obligations, taxes and dividends are fully provided for; Cash generation would be adequate to meet

all commitments during the entire repayment period.


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13. PROJECTED BALANCE SHEETS

(a) Projected B/S covering the entire period of repayment to be scrutinised; (b) CoP, MoF, Profitability estimates, Funds Flow projections and projected B/S are all inter-related

(c) Projected B/S to be scrutinised analytically with reference to all other related essential data to ensure that all the projections, made realistically and accurately,

have been woven into well co-ordinated financial statements.

14. SECURITY & MARGIN AND RATE OF INTEREST

(a) Complete details of security to be offered for the Term Loan; (b) Detailed Opinion Report on guarantors; (c) Security Margin Coverage Ratio; (d) Whether security offered

and the margin available are adequate and satisfactory (e) Credit Rating to be done and interest rate (Pricing) to be in line with this rating, unless market forces demand

otherwise

15. SPECIAL TERMS & CONDITIONS(a) Right of examination of borrower's books; (b) Restriction with regard to change in Capital Structure; (c) Restriction with regard to (i) Repayment of deposits from F&R

without the permission of the Bank (ii) Rate of interest payable on such deposits to be lower than the rate of interest charged by the Bank; (d) Restriction with regard to

transfer of controlling interest in the Co. or drastic change in the Company's management set-up without Bank's prior permission; (e) Other standard T&C.

16. ECONOMICS OF UNDERWRITING

In case of composite proposal, (a) Underwriting tie-up; (b) Capital Market trends; (c) Market response to the proposed public issue; (d) Lock-up of funds;

(e) Comparative Earnings Analysis - Underwriting Commission, Dividends, Capital Gains after Tax; (f) Comparison of total earnings thus arrived at with total earnings thatwould accrue to the Bank if the amount (Value of shares devolving) is lent by way of Term Loans for the same period


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17. CONSENTS FROM GOVERNMENT AND OTHERS

These will relate, inter alia, to (a) Industrial Licence; (b) Approval for collaboration agreement and technical know-how arrangement; (c) Clearance for import of P&M;

(d) Approval for making payments for imported P&M on deferred terms and specific clearance for tax exemption on interest; (e) Consent from Controller of Capital Issues

(f) Various approvals / No Objection Certificates from CG / SG / Local Authorities, etc. (g) Present position

18. GROUP COMPANIES

(a) Brief resume of Group Companies indicating the extent to which they are dependent on the parent company / other companies in the Group; (b) Company's liability in

respect of partly paid shares in subsidiary companies

19. MANAGERIAL COMPETENCY

(a) Company's management set-up; (b) Composition of the BoD; (c) CEO in charge of day-to-day affairs of the Company; (d) Quality of the Company's management

and the level of managerial expertise built-up within the Group; (e) Whether all departments are well served by professionals

20. OTHERS AND RECOMMENDATIONS

(a) Verify RBI's List of Defaulters / Wilful Defaulters / Suit Filed Accounts; (b) Verify ECGC's Specific Approval List; (c) Indicate the IRR for the project and comments on

comparison with the IRRs for similar projects in the same industry; (d) Indicate the importance of the project in terms of national priority and impact thereon; (e) Detail the

value of the Company / Group's connections to the Bank; (f) Whether, all considered, the proposal is a fair banking risk; (g) Recommendations for sanction of Term Loan.



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THANK YOU

Project Finance Ava

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