Project Finance

Updated on April 15, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is Project Finance?

Project finance is the strategy to raise long-term debt funding for big projects through a limited recourse or non-recourse monetary system. It aids in designing a profitable structure and delimiting the shareholders’ risks through risk diversion to other parties. Moreover, the project finance includes a brief description of its management, modelling structure, and meaning. 

What is Project Finance

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Please note that industries with a predictable market and less technical risks (power generation, infrastructure, and oil production) normally utilize this financing technique. Additionally, the project stays off the balance sheet for both sponsors and the host administration. 

Key Takeaways

  • The project finance meaning implies a financing approach that utilizes capital produced by the project to offer the creditor’s debt obligations and investor returns. 
  • There are four types of project financing sponsors: industrial sponsors, public sponsors, contractor sponsors, and financial sponsors. 
  • It has three crucial sources, i.e., debt, equity, and loan. Please note that it depends upon the structuring of the project. 
  • Typically, it is employed in industries with a predictable market and few technical risks, including infrastructure, oil production, and power generation. 

Project Finance Explained 

Project finance involves organized funding of the particular business entity generated by the sponsors utilizing debt or equity, namely, a special purpose vehicle (SPV). Moreover, the moneylender regards the capital obtained through it as a crucial compensation source.  

In the case of debtors with debt defaultDebt DefaultDebt default refers to a situation in which a borrower fails to repay loans, causing the borrower's reputation to suffer. However, before the debt is declared a default, a notice is sent to the borrower stating the debt's position and the lender's intention to declare it a default in the event of non-repayment of the debt.read more, the creditors may rightfully confiscate the said SPV’s assets. Nevertheless, the latter is not entitled to further additional assets even when the liquidating assets of SPVSPVA Special Purpose Vehicle (SPV) is a separate legal entity created by a company for a single, well-defined, and specific lawful purpose. It also serves as the main parent company's bankruptcy-remote and has its own assets and liabilities.read more are insufficient to offset the owed amount. Moreover, both technical analysisTechnical AnalysisTechnical analysis is the process of predicting the price movement of tradable instruments using historical trading charts and market data.read more and cost-benefit analysisCost-benefit AnalysisCost-benefit analysis is the technique used by the companies to arrive at a critical decision after working out the potential returns of a particular action and considering its overall costs. Some of these models include Net Present Value, Benefit-Cost Ratio etc.read more are essential before beginning the asset-based financing procedure. 

The working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)"read more produced by SPV must be certainly enough to cover business expenses and manage the debt on a priority basis, concerning capital refund and interest. Subsequently, the firm may utilize the residual income for dividends paid to financiers backing the project. 

Furthermore, it is crucial to carefully review any project framework off the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more under relevant legislation and accountancy regulations. Regarding project finance modelling, different kinds of sponsors seek a certain objective as per their preferred course of action. One of its main advantages is that it offers the project’s off-balance-sheetOff-balance-sheetOff-balance sheet items are those assets that are not directly owned by the business and therefore do not appear in the basic format of the balance sheet. However, they tend to impact the financials of the company indirectly.read more funding.

Additionally, it transfers a few project risks to debtors, such as political risksPolitical RisksPolitical risk is defined as a risk that emerges as a result of a change in a country's governing body, posing a risk to investors in financial instruments such as debt funds, mutual funds, and equities.read more and the exchange rate risksExchange Rate RisksExchange Rate Risk is the risk of loss the company bears when the transaction is denominated in a currency other than the company operates. It is a risk that occurs due to a change in the relative values of currencies.read more (as interest payableInterest PayableInterest Payable is the amount of expense that has been incurred but not yet paid. It is a liability that appears on the company's balance sheet.read more soars).

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Sponsors Of Project Finance 

To clarify, the following are four categories of sponsors:

Industrial Sponsors

The industrial sponsors are an intrinsic part of project finance management, generally lined up with a downstream or upstream business. 

Public Sponsors

Please note that these incorporate regional or central administration, municipalized firms, and municipalities with objectives concentrated on public welfare. 

Contractor Sponsors

As the name suggests, contractor sponsors establish, manufacture, or operate business units and wish to join the initiative through offering subordinated debt and/or equity. 

Investors Or Financial Sponsors

They possess a high-risk appetite, seek a considerable return on investment (ROI), and aim for capital investment in more profitable deals. 

Examples

To clarify, here are some examples to comprehend the project finance meaning

Example#1

Say, Xavier is the CEO of a multinational named Salvatore Oil Corporation (holding or parent companyHolding or Parent CompanyA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary's directions and policies.read more) with 30 years of industry experience and some stock holdings and other assets. Now, he plans on undertaking a new project through project finance management.  

Considering the risks involved, he established another firm for project development (project company) called Salvatore and Sons Oil Co. So, Salvatore Oil Co. will own mostly all or complete equity in Salvatore and Sons and possibly handle the regular business operations. 

The independent creditors will also offer loans to Salvatore and Sons for further funding. As a result, Salvatore and Sons will face insolvency in case of project failure, but Salvatore Oil (project sponsor) is not liable for the former’s debt repayment. 

Example#2

Mitsubishi Corporation (MC) and Hokkaido Electric Power Company (Hokuden) entered into the project finance arrangement with Sumitomo Mitsui Trust Bank, Ltd. and North Pacific Bank. To clarify, this agreement signed in March 2022 will assist in financing the collaborating operations of MC and Hokuden

Donan Hydro will lease current waterways and other Hokuden-owned amenities as per the plan. The latter will apply its specialization in sustaining, functioning, and constructing hydropower services to the replacement. Also, MC will utilize its vast knowledge in the project finance modelling-driven power-generation companies covering projects in both Japan and worldwide. 

Sources Of Project Finance

Now, let’s go through the below-mentioned three major sources:

Sources Of Project Finance - Major

1. Debt

It is categorized into private and public debt. Investment banks raise the former and have cheaper capital costs as debt holders are paid on a priority basis. At the same time, the administration raises public debt with more reasonable capital costs due to being a government-sponsored program. 

2. Equity

Equity financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.read more entails government-issued debt on the recommendation of an investment consultant or bank and is relatively more costly than debt financing. It is developed to reimburse higher risks presumed by the equity investorsEquity InvestorsAn equity investor is that person or entity who contributes a certain sum to public or private companies for a specific period to obtain financial gains in the form of capital appreciation, dividend payouts, stock value appraisal, etc.read more wielding the junior attestation to the project’s income and assets. 

3. Loan

It is categorized into two types, secured and unsecured loansUnsecured LoansAn unsecured loan is a loan extended without the need for any collateral. It is supported by a borrower’s strong creditworthiness and economic stabilityread more. In the former, the loan-securing assets have value as collateral, implicating the marketability and liquidity. While the latter depends upon the debtor’s basic creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more, contrary to the perfected security system. 

Frequently Asked Questions (FAQs)

Why Are Finances the Core of Every Project? 

Finances are the core of every project because the budget is fundamental to a project. Furthermore, its objectives are planned appropriately for their complete fulfillment while keeping the budget in mind. Resultantly, it plays a huge role in the decision-making process as well and is more discreetly explained in the project finance course

Why Can’t We Put Project Finance Under Corporate Finance? 

We can’t put project finance under corporate finance because, unlike the latter, it does not (or minimally) affect the corporate account report. Moreover, while the former is acquired through established SPVs investing in new projects, corporate finance is attained during the firm’s inception and (if any) expansion. 

Which Type of Projects Are Suitable for Project Finance?


The following projects are suitable for project finance:

1. Energy (like power transmission and power generation)
2. Public infrastructure (metro rail, airport, and roads)
3. Manufacturing
4. Construction
5. Telecommunication
6. Education, and 
7. Healthcare

This article has been a guide to Project Finance and its Meaning. Here we explain its management, its sources, modelling course examples, and sponsors. You can learn more about finance from the following articles: –