Fujian Farmland Sustainable Utilization and Demonstration Project (RRP PRC 47071) FINANCIAL ANALYSIS A. Introduction 1. The financial due diligence was carried out following the Asian Development Bank (ADB) Guidelines for the Financial Management and Analysis of Projects (2005) and Financial Due Diligence—A Methodology Note (2009). The project has 19 subprojects to be implemented by 19 enterprises of two types: state-owned enterprises (SOEs) and participating private enterprises (PPEs). The PPE-led subprojects are revenue generating, while those of the SOEs are non-revenue-generating.1 This analysis comprises the (i) financial evaluation of the PPE subprojects, (ii) entity financial analysis of the PPE subprojects, (iii) financial sustainability analysis of the SOE subprojects, and (iv) financial management assessment. B. Major Assumptions and Methodology 2. The main assumptions of the financial analysis are: (i) The project life will be 25 years, from 2017 to 2031: implementation from 2017 to 2021 and operations from 2022 to 2031. (ii) Subproject financial costs are based on prevailing prices in late 2015 and are expressed in constant 2015 terms.2 (iii) US dollar ($) costs are converted to Chinese yuan (CNY) at an exchange rate of CNY6.58 = $1.00, which is the prevailing exchange rate as of January 2016. (iv) The financial value of the outputs produced and inputs used is based on their domestic market prices. (v) A weighted moving average was used to forecast production, revenues, and expenses of the entities. Taking into account the importance of future developments, different weights were given to different years. The latest year weighs 50%, the second latest weighs 30%, and the third latest weighs 20%. (vi) The current business portfolio of all the PPEs will be kept the same. The project is the only change to be added to their current business portfolio. (vii) The revenue assumptions are based on increased income derived from higher crop yields due to rehabilitation of existing cropland and better tending practices, as well as higher levels of production once newly established crop areas become productive. In addition, crop values will increase due to improved product quality and attainment of green or organic certification. C. Financial Evaluation of the Participating Private Enterprise Subprojects 3. The financial evaluation aims to assess the viability of the revenue-generating subprojects. The financial evaluation was conducted by comparing the without-project and with- project scenarios. The financial evaluation is based on the comparison between the financial internal rate of return (FIRR), which represents financial benefits, and the weighted average cost of capital (WACC), which represents financial costs. If the FIRR exceeds the WACC, the subprojects are deemed to be financially viable. 4. Weighted average cost of capital. For each PPE subproject, the WACC was computed as a measure of the expected financial costs associated with financing the subproject.3 For 1 All SOEs were established by local governments, and their sustainability depends on the local governments’ financial situation. 2 Information on the basic financial costs for each of the 19 subprojects was derived from the feasibility study reports prepared by the local design institutes. 3 The WACC computation was not presented, as it differs by subproject; and presenting the computation for every subproject is not possible given the page limit. The nominal cost of the ADB loan was computed as 10-year fixed swap rate (the rate is as of 21 December 2015), plus contractual spread and maturity premium. The nominal cost 2 every PPE subproject, financing is expected from two sources—the ADB loan and the PPE’s equity. For each financing source, the real cost of capital was computed after removing from the nominal cost (2.8% for the ADB loan and 14% for the equity) the tax rate (assuming 25% for the ADB loan and zero for the equity) and the inflation rate (1.5% for the ADB loan and 2.5% for the equity). For each PPE subproject, the WACC was derived by aggregating the real costs of capital after multiplying the percentage of each financing source. The computed WACCs for all the PPE subprojects range from 3.9% to 7.3%. 5. Financial internal rate of return. For each PPE subproject, the FIRR was computed on an after-tax basis in real terms. The nominal with-project cost estimates and the financial cash flows were converted to real terms by removing the impacts of inflation and potential currency fluctuation, and the interest and other financing charges during project implementation (or construction). The FIRR was computed on an incremental with-project against without-project basis. The computed FIRRs for all the PPE subprojects range from 11.6% for Ningde Qilongxiang Agriculture Co., Ltd. to 17.8% for Ninghua Jinxi Tea Co., Ltd. 6. Financial viability and sensitivity. As shown in Table 1, the FIRR is higher than the WACC for every PPE subproject, indicating that all subprojects are financially viable. The PPE subprojects’ financial net present values range from CNY11.7 million to CNY73.2 million. Sensitivity tests were conducted individually for each of the subprojects, including project management costs. The tests assumed (i) a 10% investment cost increase, (ii) a 10% recurrent cost increase, (iii) a 10% benefit decrease, (iv) a 10% investment cost increase combined with a 10% benefit decrease, and (v) a 1-year lag in benefits. The results indicated that all subprojects are highly robust, with all FIRRs under any scenario being greater than the respective WACCs. Table 1: Financial Evaluation and Sensitivity Analysis – Private Enterprise Subprojects FIRR (%) 10% 10% 10% Investment Recurrent Benefit Participating Cost Cost Decreas Private FNPV 1-year Increase Increase e Municipality/ Enterprise FIRR WACC (CNY Benefi County (Subproject) (%) (%) million) (1) (2) (3) (1)+(3) t Lag Sanming Youxi County Youxi Shenlang Edible 13.5 5.30 44.6 12.5 13.4 12.2 11.2 12.0 Oil Co., Ltd Fujian Ninghua Ninghua County Ninghua 14.1 4.40 17.1 13.2 14.0 12.9 12.1 12.6 S&T Co., Ltd Fujian Chunhui Ninghua 12.4 6.10 17.4 11.7 12.3 11.5 10.8 11.3 Tea Co., Ltd Fujian Cuiyun Ninghua 13.8 4.80 21.8 13.0 13.7 12.7 11.9 12.5 Tea Co., Ltd Ninghua Jinxi Tea Ninghua 17.8 5.50 36.0 16.9 17.7 16.7 15.8 16.1 Co., Ltd Fujian Ninghua County Houde Ninghua Agroforestry 16.5 7.30 25.4 15.4 16.4 15.1 14.0 14.6 Ecological Co., Ltd Zhangzhou Hua'an Fujian 16.1 3.92 73,182.0 14.9 16.0 14.6 13.4 14.0 of beneficiary equity was computed based on the current 10-year government bond rate, which was further adjusted upward with other risks for project-specific factors and longer-term repayment. 3 FIRR (%) 10% 10% 10% Investment Recurrent Benefit Participating Cost Cost Decreas Private FNPV 1-year Increase Increase e Municipality/ Enterprise FIRR WACC (CNY Benefi County (Subproject) (%) (%) million) (1) (2) (3) (1)+(3) t Lag Hongsheng Gardening Co., Ltd Ningde Fujian Lvyin Jiaocheng Agriculture Co., 15.5 5.77 64,433.0 14.6 15.4 14.4 13.4 13.9 Ltd Fujian Jianye Agroforestry Zherong Comprehensive 11.6 5.16 21,022.0 10.7 11.4 10.5 9.6 10.3 Investment Co., Ltd Ningde Qilongxiang Shouning 16.1 3.92 73,182.0 14.9 16.0 14.6 13.4 14.0 Agriculture Co., Ltd CNY = Chinese yuan, FIRR = financial internal rate of return, FNPV = financial net present value, WACC = weighted average cost of capital, (1) + (3) = 10% investment cost increase plus 10% benefit decrease. Source: Asian Development Bank estimates. D. Entity Financial Analysis of Subprojects by Participating Private Enterprises 7. The project entity financial analysis was conducted to assess whether the PPE subprojects are financially viable and sustainable by assessing the impact of those investments on the financial positions of the PPEs. The project entity financial analysis included the preparation of projected financial statements (income statement, balance sheet, and cash flow) and key financial ratio analysis to test the robustness of the financial position of the borrower over time. Those key financial ratios comprise the debt service ratio (DSR) and the debt–equity ratio as debt management indicators, and the current ratio as a liquidity indicator. 9. As shown in Table 2, most of the PPEs are expected to be robust on their financial positions throughout the project period. However, Fujian Ninghua County Houde Agroforestry Ecological Co., Ltd will experience weak financial performance with a negative DSR and low current ratio in 2017, both of which will significantly improve in the succeeding periods. The provincial finance department will closely monitor the financial performance of each PPE to ensure that they will continue to meet the thresholds of those financial ratios included in the financial covenants. Fujian Ninghua County Houde Agroforestry Ecological Co., Ltd will be required to meet financial covenants from year 2022 onward. Table 2: Summary of Key Financial Indicators of Participating Private Enterprises Participating Private Enterprise Financial Ratio Threshold 2017 2022 2027 2031 1 Youxi County Shenlang Edible DSR > 1.20 274.67 13.04 22.98 22.75 Oil Co., Ltd Current ratio > 1.00 11.04 14.87 15.29 15.32 Debt–equity ratio < 1.50 0.02 0.17 0.09 0.00 2 Fujian Ninghua County Ninghua DSR > 1.20 100.72 10.69 15.97 18.66 S&T Co., Ltd Current ratio > 1.00 7.01 14.79 13.56 14.42 Debt–equity ratio < 1.50 0.05 0.16 0.11 0.00 3 Fujian Chunhui Tea Co., Ltd DSR > 1.20 3.42 6.53 41.65 49.59 Current ratio > 1.00 1.41 1.65 2.64 2.31 Debt–equity ratio < 1.50 0.06