Question 1: Essential features of project financing
In project financing, parties agree to complete a project and to provide the financial resources required to complete the project. It also embodies an agreement between the parties that when the project is completed and starts operations, it will generate sufficient cash to cover its operating and debt service requirements. Besides, it involves assurance that if the project is disrupted, additional funds to restore it will be provided through insurance among other ways.
In conventional financing, lenders consider the whole asset portfolio of the borrower to generate cash flows to repay their loans. On the contrary, lenders in project financing only consider the assets of the project and not the entire firm.
Question 2
Lenders in project financing are interested in assessing the technical feasibility, economic viability and the creditworthiness of the project. Lenders can only fund a project if its processes are technically feasible. The project must prove that it can work at the design capacity. Besides, the project must be able to generate adequate cash flows to meet debt obligations as well as operating activities. Creditworthiness relates to the likelihood of default. A lender must be assured of the creditworthiness of the project before advancing any finances to the project.
Question 3: Project risks
Completion risk: It is the risk that the project will not be completed due to lack of adequate critical supplies, inflation, among other causes. Lenders maintain that projects that fail to reach completion be taken eliminated from their investment to mitigate completion risk.
Economic risk: it is the risk that the demand for the project’s products will be insufficient to generate adequate revenues to meet the project’s financing needs (Finnerty 76). It can be mitigated by insisting on having a competent project manager since economic risk entails the efficiency of the project’s operations. Hedging techniques such as futures and forward contracts can also reduce economic risk.
Financial risk: This is the risk that the project will default in meeting its debt service obligations. A primary cause of financial risk is the fluctuation in interest rates. It can be reduced through interest rate caps and swaps, among other contracts.
Currency risk: Affects earnings, expenses, and obligations if these items are in different currencies. Unfavorable movements in the exchange rate may increase liabilities or reduce earnings.
Question 4
Preparing a financial model and project evaluation
Preparing cash flow projections: This involves estimating the cash inflows and outflows expected from the project.
Estimating the project’s total cost: the initial cost of the project is estimated, and this includes both direct and indirect costs.
Determining the cost of capital: The cost of capital is the discount rate used in evaluating projects. The determination of the cost of capital should consider the riskiness of the project.
Interest rate swap
The project can use an interest rate swap reduce the interest rate risk by converting floating interest rate obligation into a fixed-interest rate debt. This protects the project from paying higher interest when interest rates rise.
Question 5
The project will borrow from the bank and pay LIBOR + 0.5%. It will then swap the loan with a project having a fixed-interest rate. In this case, the project will pay a fixed rate of 5% and receive the LIBOR from the other party. The net interest cost will be as follows:
Pay LIBOR + 0.5% under bank loan
Receive LIBOR under swap
Pay 5% under swap
Net interest cost = 5.5%
The project will pay a fixed interest of 5.5%.
Question 6
Forward contract
Amount in US Dollars = 0.98500 × 40000
= $39,400
Call option
Option premium = 0.007500 × 40000 = $300
Amount in US Dollars = 0.987500 × 40000 = $39,500
Total (effective) cost = 39,500 + 300
= $39,800
The forward contract is a better strategy since it costs less than the option contract.
Works cited
Finnerty, John D. Project Financing: Asset-Based Financial Engineering, 2Nd Edition. John
Wiley & Sons, 2007. Print.
