JWDD036-FM JWDD036-Finnerty March 5, 2007 20:40 Char Count= 0 Project Financing Asset-Based Financial Engineering Second Edition JOHN D. FINNERTY, Ph.D. John Wiley & Sons, Inc. iii JWDD036-FM JWDD036-Finnerty March 5, 2007 20:40 Char Count= 0 vi JWDD036-FM JWDD036-Finnerty March 5, 2007 20:40 Char Count= 0 Project Financing i JWDD036-FM JWDD036-Finnerty March 5, 2007 20:40 Char Count= 0 Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Aus- tralia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. 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HG4028.C4F488 2006 658.15.2–dc22 2006052986 Printed in the United States of America 10987654321 iv JWDD036-FM JWDD036-Finnerty March 5, 2007 20:40 Char Count= 0 To my son, William Patrick Taylor Finnerty, and to his teachers at Windward School who share the joy of learning with him every day v JWDD036-FM JWDD036-Finnerty March 5, 2007 20:40 Char Count= 0 vi JWDD036-FM JWDD036-Finnerty March 5, 2007 20:40 Char Count= 0 Contents Preface xv CHAPTER 1 What Is Project Financing? 1 What is Project Financing? 1 A Historical Perspective 4 Requirements for Project Financing 6 Appropriateness of Project Financing 8 An Example 9 Conclusion 12 CHAPTER 2 The Rationale for Project Financing 13 Prior Studies’ Explanations 13 The Need for Contracts 14 The Advantages of Separate Incorporation 14 Countering the Underinvestment Problem 16 Reallocating Free Cash Flow 18 Reducing Asymmetric Information and Signaling Costs 19 More Efficient Structuring of Debt Contracts 21 More Effective Corporate Organization and Management Compensation 21 Project Financing Versus Direct Financing 22 Advantages of Project Financing 22 Disadvantages of Project Financing 29 Conclusion 30 CHAPTER 3 What Is Special about Large Projects? 31 How Large Are “Large” Projects? 32 Length of Project Contracts 36 Initial Project Capital Structure 42 vii JWDD036-FM JWDD036-Finnerty March 5, 2007 20:40 Char Count= 0 viii PROJECT FINANCING Why Studying Project Finance Is Useful 46 Why Study How Large Projects Are Financed? 50 Conclusion 52 CHAPTER 4 Who Finances Large Projects? 53 Sources of Funds for Large Projects 53 Project Bonds’ Default Risk 57 Lead Arrangers, Managing Underwriters, and Advisors 65 Conclusion 68 CHAPTER 5 Analyzing Project Viability 70 Technical Feasibility 70 Economic Viability 72 Creditworthiness 74 Conclusion as to Viability 75 Assessing Project Risks 76 Completion Risk 76 Technological Risk 77 Raw Material Supply Risk 78 Economic Risk 78 Financial Risk 79 Currency Risk 81 Political Risk 82 Environmental Risk 84 Force Majeure Risk 84 Implications for Project Financing 85 The Cogeneration Project 85 Conclusion 87 CHAPTER 6 Designing Security Arrangements 88 Purpose of Security Arrangements 89 Direct Security Interest in Project Facilities 90 Security Arrangements Covering Completion 91 Security Arrangements Covering Debt Service 92 Types of Purchase and Sale Contracts 93 Raw Material Supply Agreements 97 JWDD036-FM JWDD036-Finnerty March 5, 2007 20:40 Char Count= 0 Contents ix Supplemental Credit Support 98 Insurance 99 The Cogeneration Project 100 Conclusion 102 CHAPTER 7 Structuring the Project 103 Undivided Joint Interest 103 Corporation 111 Partnership 114 Limited Liability Company 118 The Cogeneration Project 119 Conclusion 121 CHAPTER 8 Preparing the Project Financing Plan 122 General Considerations 122 Construction Financing 126 Long-Term Financing 127 Withholding Tax Considerations 129 Estimating the Borrowing Capacity of a Project 129 Loan Repayment Parameters 130 Borrowing Capacity, Assuming Full Drawdown Immediately Prior to Project Completion 130 Borrowing Capacity, Assuming Periodic Loan Drawdowns 134 Application to a Hypothetical High-Speed Rail Project 135 Annual Coverage Tests 138 Conclusion 139 CHAPTER 9 Discounted Cash Flow Analysis 141 Incremental After-Tax Cash Flows 142 The Hurdle Rate 148 Estimating the Cost of Capital for a Project 153 Net Present Value Analysis 156 Internal Rate of Return Analysis 157 Comparing IRR and NPV Analyses 159 Conclusion 163 JWDD036-FM JWDD036-Finnerty March 5, 2007 20:40 Char Count= 0 x PROJECT FINANCING CHAPTER 10 Financial Modeling and Project Evaluation 164 Preparing Cash Flow Projections 164 Preparing Projected Financial Statements 171 Evaluating a Project’s Debt Capacity 173 Measuring Expected Rates of Return 175 Sensitivity Analysis 182 Conclusion 184 CHAPTER 11 Using Real-Options Analysis to Evaluate a Project 186 Description of the Oil Field Project 186 Project’s Real Options 187 Evaluating the Project 190 Traditional DCF Analysis 205 Sensitivity of Option Value to Oil Price Volatility and to Reserve Dispersion 206 Conclusion 208 CHAPTER 12 Sources of Project Funds 209 Equity 210 Long-Term Debt Market 213 Commercial Bank Loans 214 Fixed-Rate Debt Market 219 International Capital Market 227 Supplier Credits 231 Governmental Assistance 231 World Bank Loans 236 Inter-American Development Bank 237 Local Sources of Capital 237 Conclusion 238 CHAPTER 13 Managing Project Risks 240 Interest-Rate Swaps 240 Credit Default Swaps 245 Options 251 Forwards and Futures 257 JWDD036-FM JWDD036-Finnerty March 5, 2007 20:40 Char Count= 0 Contents xi Hedging 260 Hedging with Options 262 Hedging Foreign Exchange Risk 265 Conclusion 272 CHAPTER 14 Issues for the Host Government 273 Contribution to the Host Jurisdiction’s Economic Development 273 Host Jurisdiction’s Expected Economic Return 274 Impact on the Availability of Hard Currency 275 Exposure of the Host Government to the Project’s Obligation to Repay Project Debt 276 Desirability of Precedents 277 Hibernia Oil Field Project 277 Public–Private Infrastructure Partnerships 278 Public–Private Financing Structures 280 Legislative Provisions that Can Affect Public–Private Partnerships 283 Conclusion 287 CHAPTER 15 Case Study: The Indiantown Cogeneration Project 288 Project Description 288 The Partnership and the Sponsors of the Project 293 Principal Project Contracts 296 Projected Operating Results 302 Project Financing 306 Conclusion 318 CHAPTER 16 Case Study: The Tribasa Toll Road Project 319 The Mexican Government’s Toll Road Program