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Debt, Equity and Capital Structure

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Debt, Equity and Capital Structure Abstract TitleofDissertation:ProjectPerformance-BasedOptimalCapitalStructure ForPrivatelyFinancedInfrastructureProjects SatheeshK.Sundararajan,DoctorofPhilosophy,2004 Dissertation directed by: Assistant Professor Chung-Li Tseng Department of Civil and Environmental Engineering Privately Financed Infrastructure (PFI) projects are characterized by huge and irreversible investments and are faced with various risks. Project performance risks, such as project completion time and costs, affect the project value significantly, par- ticularly in project development phase. This is because a major part of the project investments is made during this phase. Due to high uncertainties in managing the project performance risks, the selection of optimal financial structure is a challenge to Project Company sponsors and Lenders. Conventional project performance mea- surement and valuation methods cannot capture the dynamics of risk variables and their impact on the project value. Without such dynamic performance information, the decision of capital structure may not only be suboptimal, but lead to erroneous results. This research proposes an uncertainty evolution model, with which the dy- namics of the project performance risk variables can be predicted at any desired time over the project development phase. A dynamic capital structure model is proposed that explicitly considers the performance risks and adjusts the capital structure dy- namically to counter the impact of performance risks. Numerical results show that such a model can add a significant value to a PFI project. Two risk-sharing mechanisms are incorporated in the capital structure for a PFI project: active project management (self-support) and government support. An ac- tive project management method called dynamic crashing is proposed. By dynam- ically controlling the project performance through dynamic crashing, we show that the project value can be improved and the chances of potential bankruptcies can be reduced. In addition, the significance of government support as a risk-sharing mech- anism is also modeled, which may be viewed as another means to protect the Project Company against the potential bankruptcies and improves the project value. Numer- ical results are implemented to validate the models. Overall, this research contributes an integrated framework to capital structure decisions for projects with performance uncertainties. Project Performance-Based Optimal Capital Structure For Privately Financed Infrastructure Projects by Satheesh K. Sundararajan Dissertation submitted to the Faculty of the Graduate School of the University of Maryland at College Park in partial fulfillment of the requirements for the degree of Doctor of Philosophy 2004 Advisory Committee: Assistant Professor Chung-Li Tseng, Chairman/Advisor Associate Professor Zhi-Long Chen Assistant Professor Nengjiu Ju Professor Paul M. Schonfeld Associate Professor Alexander J. Triantis c Copyright by Satheesh K. Sundararajan 2004 Dedicated To My Parents ii Acknowledgment To begin, I give my deepest gratitude and sincere appreciation to my advisor, Dr. Chung-Li Tseng. Without his advice and consistent encouragement, this research could never have been completed. I also would like to thank the other members in my dissertation committee, Dr. Paul Schonfeld, Dr. Alexander Triantis, Dr. Nengjiu Ju and Dr. Zhi-Long Chen for their invaluable suggestions and comments. My special appreciation and best regards are expressed to the other faculty and staff in this department, including Mr. John Cable, Dr. Gregory Baecher, Dr. Mark Austin, Dr. Steven Gabriel, Mr. Al Santos, and Ms. Maggie Gray for their help during my doctoral study. A thank-you is also deserved for my fellow graduate students and friends, Tong Zhao, Wei Zhu and others for many helpful discussions. In addition, my gratitude extends to my roommate Abhishek for his help in programming. A special thanks goes to my colleague Justin Bell for his persistent effort in reading and commenting on the report. Finally, I thank my family - my parents, brother, and sister for their love, support and encouragement to me throughout this endeavor. And to my fiance, a special thanks for the constant support in completing this report on time. iii Table of Contents List of Figures viii List of Tables x 1 Introduction 1 1.1Motivation................................. 1 1.2 Project Performance Risks and Optimal Capital Structure for PFI Projects.................................. 2 1.3ObjectivesofResearch.......................... 4 1.4OriginalContributions.......................... 4 1.5OrganizationoftheDissertation .................... 6 2PFIProjects:AnOverview 8 2.1ParticipantsinPFIProjects....................... 8 2.2ProjectFinancing:Debt,EquityandCapitalStructure........ 11 2.3UncertaintiesandRiskAllocationStrategiesforPFIProjects..... 12 2.4ProjectManagementofPFIProjects.................. 15 2.5TheNeedforanIntegratedModel.................... 16 2.6MajorAssumptionsintheResearch................... 17 iv 3 Literature Review 18 3.1PrivatelyFinancedInfrastructureProcesses.............. 18 3.2ProjectandInfrastructureFinancing.................. 20 3.3 Risk Management Strategies and Government Support . ...... 21 3.4 Project Valuation Methods, Real Options and Capital Structure Theory 24 4 Modeling Dynamics of PFI Project Performance Risks 27 4.1PFIProjectRisksandRiskManagement................ 27 4.1.1 Projectperformanceriskmanagement............. 28 4.1.2 The need for a project performance risk based capital structure model............................... 32 4.2ModelDynamicsofProjectPerformanceRisks............. 34 4.2.1 Notation.............................. 35 4.2.2 Time-at-completion T˜(t) and cost-at-completion C˜(t)..... 36 4.2.3 Processforprojectdurationevolution.............. 41 4.2.4 Processforprojectcostevolution................ 43 4.2.5 ComparisonwithCPMandPERTmodels........... 44 4.2.6 Interdependencyoftheuncertainties.............. 45 4.2.7 Meritsoftheproposedprojectperformancemodel....... 45 5 A Generic Model for Optimal Capital Structure 47 5.1Performance-BasedDynamicCapitalStructure............. 47 5.1.1 Modelassumptionsanddiscussions............... 48 5.1.2 Notations............................. 50 5.2ModelingOptimalCapitalStructure.................. 51 5.3NumericalResults............................. 63 5.4Conclusion................................. 71 v 6 Optimal Capital Structure Model with Active Project Performance Management 72 6.1ProjectTime-CostTradeoffDecisions.................. 73 6.2DynamicActivityCrashing....................... 75 6.3CapitalStructureusingDynamicProjectCrashing.......... 77 6.4 Solution Procedure for Solving (P2)................... 83 6.5NumericalExample............................ 85 6.6LimitationsofDynamicCrashing.................... 89 6.7Conclusion................................. 90 7 Optimal Capital Structure with Government Support Option 91 7.1 Introduction to Government Support . ................. 92 7.2 Forms of the Government Support . ................. 92 7.2.1 Loansandguarantees....................... 92 7.2.2 Equityparticipation....................... 93 7.2.3 Subsidies . ............................ 93 7.2.4 Taxandcustomsbenefits.................... 94 7.2.5 Protectionfromcompetition................... 94 7.2.6 Othersupports.......................... 94 7.3 Effects of Government Support ..................... 94 7.4 Dynamic Government Support ...................... 96 7.4.1 Optimal capital structure with dynamic government support . 97 7.4.2 Basicassumptions........................ 98 7.4.3 Notation.............................. 99 7.4.4 Modelingoptimalcapitalstructure............... 99 7.4.5 Case 1: Government support as an explicit rescue mechanism atbankruptcy........................... 101 vi 7.4.6 Case2:Governmentsupportisanoption............ 105 7.5NumericalTests.............................. 107 7.6Conclusion................................. 111 8 Summary and Future Directions 113 vii List of Figures 1.1Organizationofthedissertation..................... 7 2.1AtypicalPFIprojectstructure..................... 9 4.1Typicalperformanceratefunctions................... 38 4.2 An example of activity duration evolution process at time t (assuming constant work rate pj) .......................... 43 5.1Typicalcashflowprofilefortheconcessionperiod........... 52 5.2Projectnetworkdiagram(doublelineshowsthecriticalpath).... 65 5.3EffectofminimumequityconstraintonNPV.............. 68 5.4EffectofcorporatetaxesonNPV.................... 69 5.5EffectofdebtrepaymentperiodonNPV................ 70 5.6EffectoflengthofterminationperiodonNPV............. 71 6.1Typicaltime-costtradeoffprofileforanactivity............ 74 6.2 Example of two crashing options and their corresponding time and cost behaviors................................. 78 6.3Effectofcrashingcostonprojectvalue................. 87 6.4ImpactofvariationsincrashcostsonProjectvalue.......... 89 viii 7.1 Functional relation between α>1andβ<1 such that the project value matches the benchmark $247M, obtained in Chapter 5 ..... 109 7.2Effectofmaximumgovernmentequityonprojectvalue........ 110 7.3 Effect of cost of capital (W min)constraintonprojectvalue....... 111 ix List of Tables 5.1Projectspecificdata........................... 64 6.1Crashingoptioninformation....................... 86 6.2Summaryoftestresults......................... 87 7.1SummaryoftheresultforCase1 .................... 108 x Chapter 1 Introduction 1.1 Motivation UNCITRAL (2001) legislative guide on privately financed infrastructure projects
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