Project Financing - Interest Rate, Exchange Rate, Inflation Rate, Political and Environmental Risks - Example

ABC REPORT ANALYSIS Prepared by (Student’s Name) Course Name University Name Professor’s Name Date A. Project Financing Recommendation Taking a closer look at the different analysis models; it can be vehemently established that the project financing is fairly positioned. The management can go ahead and adopt a project financing approach as opposed to corporate financing. Results perfectly indicate a positive position in relation to the payback period, discounted payback; equity IRR and Project IRR; DSCR; CAPM; WACC and NPV, which posits that the firm will be able to generate substantial level of profits over the period. Notably, it is recommended that the management ensure to adopt project as opposed to corporate financing model for this particular undertaking reason being; First, project financing allows for a nonrecourse or restricted recourse debt structure. This means that the project finance lenders to the water treatment facility will enjoy limited or no level of recourse to the underlying project sponsor indicating that these sponsors will have no degree of liability to the lenders for breach or default of this financing agreement while the finance lenders’ recourse can only be pledged to the underlying collateral indicated (Brealey, Cooper & Habib, 1996). In essence, the sponsor’s financial risk is only restricted to the amount of capital contributed to aid the water treatment facility. Thus, it means that the project will attain a great deal of financial independence while making sure to protect the sponsor’s assets from any given challenge that would face the project. This way, the sponsor’s risks are minimized in comparison to when corporate finance techniques are adopted. Consequently, Brealey, Cooper and Habib (1996) notes that project financing allows for off-balance sheet treatment whereby sponsors are cushioned off against their liabilities in regards to the project at hand; inclusive of the debt levels. In consequent, ABC Pty Ltd water treatment facility project should adopt the project finance since it has the capacity to protect from possible restrictive agreements in regards to other financing documents (Miglo, 2010). It is important to note that in the conventional cash flow borrowing arrangement and project sponsors could only be subjected to limited financial agreements within their underlying corporate loans or even credit arrangements. However, in the event that project financing is adopted then it is clear that it would be a separate venture and unique from the sponsor’s other undertakings; activities or even operations for that matter. Following this line of argument, then it is possible that the restrictive agreements that are mostly associated with corporate loans would not affect the sponsor’s individual undertakings. Above all, ABC Pty Ltd should consider project financing approach especially since it provides for a generally favorable financing covenants. Given the fact that project lenders evaluate the underlying project in relation to its risk allocation, the water treatment facility would enjoy even better terms because of its of positive NPV and Payback periods (Miglo, 2010). Of particular interest to note, the overall project undertaking allows for risk sharing so that the company is shielded from possible unexpected occurrences since its is distributed across all project participants. As a result of this feature, the undertaking is surely fairly-positioned to achieve the overall initial objectives. B. Project Risk Analysis 1.0 Interest Rate Risk It is important for ABC Pty Ltd to comprehend the fact that interest rate risk should be at all times managed and mitigated for that matter since it can impact on its overall profitability as a whole. The current 80% of the total capital expenditure related to the water treatment facility is expected to be funded by 11% interest rate bank borrowings; with repayment starting in a year or so. It is critical to note that any possible adverse changes in interest rate changes will result to enormous increase in the level of borrowing costs; returns expected returns for the project sponsor’s; decrease the expected level of profitability levels of the project in the long run; and, also possibly reduce to a greater extent the imminent net present value of the entities as a result of the unforeseen possible alterations in the discount rates on the base value of the borrowings and return on projects (CPA Australia, 2008). Following this line of reasoning, it is important that ABC Pty Ltd engage in measuring interest rate risks prior to commencing the water treatment facility project. The process of measuring this risk could adopt a sensitivity analysis where changes are monitored and compared against numerous accounting income or even economic values of the project at hand. To effectively mitigate this level of risk from affecting the project, management team should ensure to request the bank to fix the interest rate for the loan within the course of repayment (CPA Australia, 2008). This could be strengthened by converting the fixed rate loan to a floating loan status by way of using a derivative like interest rate swap. Notably, the project can opt for a floating rate cost of funds that is seemingly useful for purposes of protecting against interest rates through an interest rate cap (CPA Australia, 2008). In fact, this mitigation approach can be compared to insuring the interest expense against possible rise in the future. 2.0 Exchange Rate Risk Papaioannou (2006, p.3-6) ascertains that this form of risk is likely to affect the overall value of the project at hand especially since transactions between suppliers and customers of the proposed water treatment facility are conducted in dollars. It results from possible direct loss, which is a component of un-hedged exposure, in the project’s overall cash flows over the period in time for which it will start generating cash. The forms of exchange rate risks present in this project include; the transaction risk that is basically manifested whenever dealing with the supply of the treated water and purchase of raw dirty water from the seller (Kritzman, 1993). It further affects all transactions that relate to exposures emanating from receivables and payables. It also involves economic risk that is manifested through the project’s present value of future operating cash flows that is caused by exchange rate shifts (Kritzman, 1993). It is crucial to note that the economic risk is vehemently affected by exchange rate alterations on revenues as well as overall operating expenses related to cost incurred as a result of domestic inputs and imports. To effectively ensure that this form of risk is mitigated holistically, then ABC Pty Ltd should adopt different hedging strategies. In fact, as a way of mitigating transactions-based risk, the project management should adopt tactical hedging in order to hedge their transaction currency risk in relation to possible short term receivables and payable transactions like in the case of purchasing the untreated water from Dirty Water Pty Ltd and embrace strategic hedging for longer-period transactions. It should mitigate the economic-based exchange rate risk through a residual model. This should involve measuring the potential impacts of the exchange rate deviations from an underlying benchmark rate that is adopted to forecast the project’s revenues and cost streams over the period for which it will run (Kritzman, 1993). Notably, the project management can opt to come up with a risk oversight committee that would be tasked with the responsibility of approving limits on matters related to position taking and analyze the appropriateness of hedging instruments as well as VaR position on a regular period. 3.0 Inflation Rate Inflation risk is highly attributed to the impact of the underlying economic conditions. The water treatment facility project is subject to these alterations within the economic environment for which it is positioned. It thus goes without saying that the project management should come up with effective mitigating strategies in order to protect possible interferences from inflations. To effectively mitigate this form of risk; the project management should embrace the use of inflation derivatives for its cash flows (Voegtlin & Pfau, 2013). These derivatives greatly involve liquid indices whereby index-linked bonds market are present especially in a process known as swap format. According to Voegtlin and Pfau (2013, p.23) swap format should be adopted for the purpose of enhancing a complete replicate of liability of cash flows sensitivity statuses in the future period for which they will be realized. 4.0 Political and Environmental Risks During the different life cycle of the water treatment facility project; it is possible that the entire process would be faced with a distinctive set of political and environmental risk that could include delayed construction permits from the local administration agencies, community opposition, alterations from the asset-pricing policies amongst others (The Boston Consulting Group, 2015). This type of risk posits that there would be an imminent level of possibility that underlying political authorities might go ahead and interfere with a timely development for long-term economic viability of the entire undertaking. To mitigate political and regulatory environmental-based risks from affecting the project, the management might opt for incorporating such financial instruments like political-risk insurance coverage or guarantees to cushion-off the undertakings incase of instability (The Boston Consulting Group, 2015). It can also seek to incorporate distinctive ownership structure of the project so that the co-financiers of the project could be chosen from the most popular multilateral development banking institutions or even adopt investors from the foreign countries or economic regions. References List Brealey, R., I. Cooper & M. Habib.1996, "Using Project Finance to Fund Infrastructure Investments". Journal of Applied Corporate Finance vol.9, p.25 - 38 CPA Australia 2008. Understanding and Managing Interest Rate Risk, Finance & Treasury, Retrieved on May 23, 2016 from http://www.cpaaustralia.com.au/~/media/corporate/allfiles/document/professional-resources/business/understanding-and-managing-interest-rate-risk-guide.pdf?la=en Kritzman, M., 1993, “The Optimal Currency Hedging Policy with Biased Forward Rates,” Journal of Portfolio Management, vol. 19, no.4, p. 94–101 Miglo, A. 2010. Project Financing versus Corporate Financing under Asymmetric Information, Journal of Business & Economics Research, vo.8.no.8, p. 27-42 Papaioannou, M. 2006. Exchange Rate Risk Measurement and Management: Issues and Approaches for Firms, IMF Working Paper, 06/255, p. 1-20 The Boston Consulting Group. 2015. Strategic Infrastructure: Mitigation of Political & Regulatory Risk in Infrastructure Projects. World Economic Forum. Retrieved on May 23, 2016 from http://www3.weforum.org/docs/Media/WEF_RM%20Report%202015.pdf Voegtlin, R & Pfau, W, D. 2013. Mitigating the Four Major Risks of Sustainable Inflation-Adjusted Retirement Income, The White Paper. Retrieved on May 23, 2016 from https://www.immediateannuities.com/pdfs/articles/mitigating-the-four-major-risks-of-sustainable-inflation-adjusted-retirement-income.pdf Read More