Project Finance and Procurements - Essay Example

BPMA706 PROJECT FINANCE AND PROCUREMENTS By Location 5. How would you negotiate a possible price at which to sell the project to a new operator? Project Finance To identify and settle on the possible price to sell the project, it is first imperative to outline how project financing takes place. Project finance is directed to the long-term infrastructure, public services and industrial projects whose source of initial capital investment comes from the equity and project debt (Esty, 2014). In return, the initial capital financing is paid from the cash flow that would be generated as a return on investment. In simple terms, project financing refers to the loan structure that primarily relied on the cash flow for the repayment of the debts. In this regard, the assets, interests, and rights of the project are basically held as the secondary security or act as the collateral. Therefore, in any case the forecasted cash flow from the project does not sustain the project, there is high risk exposure to debt risks though the failure of the projects may be attributed to many factors like the interest rates, business risks, economic situation like inflation and the type of the shareholders (Gatti, 2013). In the case of Autopistas del Centro, the financial recession hit the project quite since most of the projected cash flow had been forecasted prior to the great financial crisis of 2008 (Lubian, 2015). Therefore, the only option it to sell the project to new owners since the shareholders are reluctant to go into their pockets and revive the project once. Therefore, it is imperative to identify some of the factors that must be considered when pricing the project so as to make sure both the buyers and sellers are satisfied. Besides, the head of the projects is deeply concerned about the best approach that can be used to make sure that the shareholders are satisfied with the handing over of the project to the new owners. Inflation and the international capital market Inflation is one of the critical issues that must be looked into when pricing a project to the new owners. The implication is that inflation has the potential to increase the original estimates of the construction costs (Esty, 2014). Usually, the inflation rates are put into consideration when the project is at the design stage but future changes in the inflation rates may affect the original estimated construction costs and this will have a huge effect on the final pricing of the project (Gatti, 2013). Therefore, when pricing the project, it would be important to look at the inflation rates in Spain, as well as Europe in general. In 2009, the CFO of AC, Martinez saw the need to revise the status of the project finance under different circumstances under which the project had initiated and planned (Lubian, 2015). There was an imminent drop in project’s operating income owing to the raging global financial crisis that threatened the viability of the project. Though the financial crisis brought about deviation from the original investment plan, the project had been implemented successfully. However, the 2008 financial crisis brought about a 12% drop in the forecasted revenue thus there was the need to revise the business plan to match the anticipated financial recovery before 2013 (Lubian, 2015). Therefore, while pricing the project, these are some of the factors that must be considered both by the buyer and the seller since it affects the valuation of the project. From 213 through to 2026, the return on investment would fall to 7.02 as opposed to the 7.62. Therefore, to get the 7.62 return on investment, the business plan was revised implying that more capital was needed to make the project viable and this would be considered in the valuation of the project to the buyers. The stakeholders Stakeholders are the people with vested interests in the project and, in this case, the investors or the shareholders are the main factors to consider when pricing the project (Esty, 2014). In this case scenario, the shareholders are either involved directly in the construction of the project or involved in its major operations. Therefore, from the case scenario, the shareholders were deeply concerned with getting a fair deal from exiting their investments from AC. The interests of the shareholders would be later portrayed as they appointed the CFO to negotiate the fair price for selling the project. Therefore, to sell the project fairly that all the stakeholders are satisfied, the CFO has to set the minimum price at which the stakeholders would have sold the company in the late 2009 so as to achieve the anticipated return on investment of 7.62 percent based on the modified or the revised business plan (Lubian, 2015). On the other hand, the buyers would determine the suitability of the price by looking new business plan since it has undergone both operational and financial improvements. For stakeholders, a fair pricing is only achieved if the income reflects the reduction in revenue and that the operational improvements would lead to the reduction in operating costs. From the case study, it is evident that the operational costs are reducing tremendously from 10% in 2010 to 5% in 2011 and eventually 2 percent as the project start reaping from the financial recovery of 2013 (Lubian, 2015). Risks When acquiring new project finance, the buyers have to identify the extent to which the business is exposed to risks (Esty, 2014). In this case, the new owners have to evaluate and appraise the project based on the extent to which it is vulnerable to uncertainties like the inflation rates. Spain, for instance, has a long history of both negative and positive inflation rates though the effect depends on the global financial conditions. For instance, the property was valued when the country had been recording an attractive economic situation, from the GDP, unemployment rate, inflation rates, and the interest rates. In this regard, the project must be re-valued as the sale is taking place after the risk from financial crisis hit it hard thus affecting the cash-flow, as well as the overall revenue generation potential. The other important aspect of risk is how the country is exposed to business risks. In this regard, the risk-free interest rate of Spain must be put into consideration before settling on a final price. In 2004, for instance, the risk-free interest rate for Spain stood at 2.00% while in 2009; the risk levels reached 3.00% (Lubian, 2015). Therefore, debt rates, since the project is highly indebted, should take into consideration the amount the new owners will have to bare so that the business is not exposed to too much risk. The financial aspects of the investment An important source of initial capital for most project finance come in the form of debts from a pool of banks as in the case of Autopistas del Centro (Lubian, 2015). In this case, the business has to ensure that the revenue generated is enough to cater for the debts so that the project can maintain an attractive liquidity level. On the other hand, part of the initial capital investment came from the shareholders who think that the debt situation cannot allow them to continue supporting the project from their own pockets. Therefore, to sell the company, it is imperative for the new and previous management must come to a consensus on had to settle the debts and also ensure that the stakeholders are given according to the investment they injected into the project (Esty, 2014). Credit rating Credit rating is used by the lenders to determine the extent to which a company is able to borrow and sustain its debts (Berk et al., 2013). In this case, the credit rate for the project must be determined because it affects the companys ability to borrow. However, the projects debt situation has placed it in a bad situation thus its credit rating is not attractive, and this may affect the final pricing of the project. Another important factor to consider is the average debt service ratio as anticipated to cover the entire life cycle of the project. Initially, the company anticipated and established a DSCR of 1.5% (Lubian, 2015). The DSCR, in this context, refers to the ratio between the free cash flows and the overall debt servicing, inclusive of the interest as well as the related charges (Berk et al., 2013). Therefore, the sale of the project can only take place fairly to the buyers if the debts are negotiated. For instance, there is already an anticipation to establish another repayment schedule of the debts as of 2012. In this regard, the exiting management must make the adjustments with the relevant banks before handing over the investment to the new owners. However, the new debt conditions proposed by the current management is attractive as the conditions are adjusted to review the debt costs and debt servicing due to public guarantees since the client for the project is the central government of Spain that can subsidize the project. The Ministry of Industry has guaranteed to subsidize AC so as the ratio of the Free Cash flow to the total debt service remains lower than one (Lubian, 2015). Therefore, there are already plans to cover the debts implying that the new owners are not being handed a debt burden they cannot bear. Following on from question 5 above, analyze a price for each side: seller (current shareholders) and buyers (new operator). Would you consider alternative options? The price for the current stakeholders For the current stakeholders, the best prices must be arrived at based on the level of investment they have injected into the project. On the other hand, the final price settled on must also depend on the cash flow generated from the project, whether it can support the debt servicing. Besides, the prices must be calculated taking other factors like interest rates into consideration. In addition, for the stakeholders, they believe that the project is to be priced based on the available reserve fund they have set aside to take care of the necessary and the recommended cash flow. Since the business plan was revised, it is also imperative to consider the new return on investment for the stakeholders. For the new business plan, the projected payback period was estimated to be 13 years, implying that the project would rich its ultimate maturity in the next 13 years, and that is 2026(Lubian, 2015). In this regard, the prices for the stakeholders must be adjusted to take into consideration the 7.62% fall in return on investment holding other factors like debt coverage, inflation rates, and debt servicing into consideration. The pricing to the stakeholders can also be done based on the Internal Rate of Return; usually the discount rate for capital budgeting that makes the current net value of the project’s cash flow to be zero. Therefore, the higher the IRR the more desirable a project can be undertaken. Initially, the IRR or the return due to the stakeholders, based on their FCF, was 8.09 % but the financial crisis led the project to assume unattractive debt condition thus, the new projections for the new business plan is 7.62(Lubian, 2015). Therefore, for the stakeholders, the project can only be sold fairly is their IRR on the FCF is maintained at 8.09%. As the CFO has estimated, if the senior and subordinate dates are put into consideration, the project would be valued at €70 million as the debt stood at € 51 (Lubian, 2015). In this case, the value of the equity will be roughly €19 and if this is added to the value of the debts, then the project can be sold at €70M to cater for the 7.62 % IRR of the shareholders’ free cash flow. Nonetheless, the prices can be calculated based on the projected value of the project’s liquidation, forecasted as at 2026. From the company figures, the FCF associated with liquidation would be valued at approximately 19 million and this added to both the subordinate and senior debts almost equals the € 70 to be the selling price of the project (Lubian, 2015). Therefore, going by the 7.62 % IRR of the shareholder’s cash flow, selling the project at €70M would be fair enough for the stakeholders as their rate of return on cash flow would have been taken into consideration. Price for the buyers For the buyers, the new prices should be set taking into consideration the revised business plan. From 2008 through to 2012, the project was revised to cater for the revenue reduction as the figures reduced from 12% in 2008 to 2% (Lubian, 2015). Therefore, the new operator is buying the project when it has already picked up in terms of revenue collection implying that the business is being acquired under acceptable and manageable risks. The 2% fall in revenue can be recovered within a very short period of time because there have been some improvements on the operation costs. On the other hand, the new operator must consider the debt situation before agreeing on the best price to pay for the project (Gatti, 2013). However, the new business provisions or the revised plan already has some incentives to renegotiate the debts, where there is already ten-year schedule for repaying the debts dated from 2012. Besides, the new operator is acquiring the project when the new debt conditions are been adjusted into better terms by considering new business costs and debt servicing. The new improvements on debts are due to the additional public guarantees that new owners will enjoy. The government has support for the project because the freeway project is a very important public service. Besides, the debt situation is boosted by the fact that the government is actually anticipating, through the ministry of industry, subsidize the project so that the FCF to total debt service ratio would be recorded lower than one. Nonetheless, the new interest rates are being set at 6% (Lubian, 2015). For the new buyers, depreciation of the assets should also be considered before arriving at the final price. From the company figures, the debt situation has negative implications on the project’s asset value as most might be depreciating though the figures indicate that the rates and bearable for the new operators. In this case, the €70M price is still an attractive price for the buyers considering the new operator would be responsible for the 51 though the government has put incentives to make sure that the debt servicing of the project is covered in the next five years since the facility provides important public services (Lubian, 2015). Therefore, the price will imply that the shareholders have a fair share from the buyout of the company and also the new operators are not inheriting the debt risks from the previous owners. In this case, the new operators should pay a price that caters for the shareholder’s FCF 7.62% while also maintaining the projects FCF of 7.02%. Nonetheless, the new price must be a subject to the VAT and the rate should be reflected in the initial capital investment and setting up of the equity (Humphreys, 2014). However, a project that is partly funded by the government may be exempted from too much taxing since the government also supports the initiative as a public service. Therefore, since the VAT rate of 3.5% will be maintained then the project should be bought at €70M as it has already taken care of the expenditure in terms of taxes and cash flow used to finance or service the debts (Lubian, 2015). Alternative prices Shareholders/sellers Alternatively, the shareholders can make good profit from the sale of the project by selling the project to consider all their expected and anticipated returns despite the financial crisis, the inflation rates and the risk-free rates of the particular country, Spain in this case (Humphreys, 2014). In this case, they can stick by the initial estimated cash flow return of their IRR as initially estimated to be 8.09 %. If the shareholders go by this cash flow rate on as part of their return on investment, then it will be possible to sell the project at a higher price, say the €75. 75M (Lubian, 2015). Besides, the new value for selling the project would be based on the depreciated levels of the expenses as the values are expected to stagnate by 2026 when the business will realise good returns. In this regard, the shareholders will opt for making good profits from the sale of the project so as to recover the hard financial times that had exposed the project to risk in 2009. Buyers/new operator The new operator or the buyer can also reconsider the CFO initial offer of €70M and determine the extent to which the business has the potential to bring in good rooms in the near future (Lubian, 2015). In the years of operations, most of the revenue accrued from the project will be directed to settling the debts though the revised business plan has provisions for renegotiating the debts. On the other hand, the new operator should least consider the government’s promise to subsidize the debt situation since there are operational costs that still need to be incurred (Bender, 2013). Therefore, the alternative price should be renegotiated in terms of the free cash flow of the project, as the new projections stand at 7.02% but it is not quite certain that the business will stabilize at this value as the economy has not recovered to the full potential (Lubian, 2015). Therefore, alternatively, the buyer can bid a lower price, than € 70M, so as to take care of the entire business risk situation, including the debt and reducing levels of revenues. On the other hand, the price should be based on the country’s GDP that at the moment is fairly attractive for investment. Bibliography Bender, R 2013, Corporate financial strategy, Routledge. Berk, J, et al., 2013, Fundamentals of corporate finance, Pearson Higher Education AU. Esty, B 2014, ‘An Overview of Project Finance and Infrastructure Finance-2014 Update’, HBS Case, (214083). Gatti, S 2013, ‘Introduction to the Theory and Practice of Project Finance’, Project Finance in Theory and Practice (Second Edition), pp. 1-25. Gatti, S 2013, Project finance in theory and practice: designing, structuring, and financing private and public projects, Academic Press. Humphreys, K. K 2014, Project and cost engineers handbook, CRC Press. Lubian F.J.L, 2015, Project Finance for Autopistas Del Centro, University of Westminster. Read More