The Project and the Risks that Might Affect Them - Research Paper Example

?Introduction Project financing is a term that is used to refer to the techniques used in the financing of projects in many sectors, and is emerging as the technique of choice for project managers1. The technique is innovative and is currently preferred by many corporate bodies as a means of ascertaining the feasibility of finance projects. Mainly, in determining the feasibility of engineering and natural resource projects, the concept of project finance has taken precedence. In the project world, project finance is increasingly taking precedence for financing infrastructure and determining the feasibility of large-scale projects. One of the major aspects of project financing is understanding the reason for project financing, preparing the financial plan, determining the risks of the project, designing the project, and sourcing the required finance for the completion of the project. The last aspect of project financing, sourcing the funds, requires a broad knowledge for designing contractual agreements, to support the bid or finances. In many cases, the financiers of the project will include government agencies, private partnerships, financing structures, and major financial institutions. The financing institutions will usually require an analysis of the project so that the credit requirements of the borrower can be ascertained, the borrowing capacity of the project be ascertained, and the project analyzed in terms of cash flows, expected return and the repayment of the cost. The financing institutions will take into account the tax and accounting issues of the project and the risk factors to determine the feasibility of completion and the chances of repayment. In this case, the concept of bankability refers to the consideration taken by a lender to determine whether a project is feasible and will repay the loan provided for its implementation2. A project in finance is usually considered bankable if the major providers of funds are willing to lend to finance the project. Many projects are funded on a project finance consideration, where a special procedure is set to determine the estimated cash flows and determine whether the project is feasible. In terms of bankability, the project financier will assess the expected cash flows and duration of the project; assess the risks associated with the project to determine whether the project is a credible choice for financing. The financing for a project is usually repaid through the cash flows earned from a project, and a financier will always look to the assets and revenues of the project before extending a loan. In traditional forms of finance, the financier will consider the past credit performance of the borrower and determine the ability to repay a loan, but in project financing, the lender considers the ability of the project to repay its financing. The subject of risk of the project is also important since the lender usually has no recourse to the project assets; therefore, the expected cash flows are used to repay the loan3. This means that the credit risk associated with the borrower is of no consequence, instead, the risk associated with the project determines the amount and duration of the loan being extended. However, before the lender decides whether to lend to the project controllers, some risk issues have to be assessed and the project itself analyzed. According to Vinter4, bankability differs in terms of the deal itself, the market for the project, and the risks associated with the project. This means that different projects have different associations for bankability, depending on the lender’s view of the feasibility of the project. This paper will analyze the risks that lenders will analyze when considering the bankability of a project, the steps taken to mitigate these risks, and the decisions regarding the bankability of projects. The paper will then exemplify the issue of bankability using already completed projects in the global market. Risk minimization process The consideration of the bankability of a project is usually centered on the risks of the project being financed5 (Morgenson, 2011). As already stated, the project usually has no recourse for the lender, meaning that the lender has to depend on the cash flows of the project to repay the loan extended. The risk taken on by the financier is usually great since the cash flows can only be realized when the project is operational, and if the implementation of the project fails, the financier is likely to lose a major part of their money6. The assets used in these kinds of projects are usually highly specialized and are likely to remain in remote locations, so the lender has little or no change of recovering their loan against the assets. Since the assets are highly specialized, there is usually a small chance of a high resale value against the assets. Therefore, the efforts of the lenders and advisers in determining the bankability of a project are not surprising, considering that the project risks have to be minimized as mush as possible. The cost of financing is also usually higher since the risks associated with these kinds of projects are usually higher than normal financing projects. Risk minimization process As already stated, the financing of a project is usually achieved from the cash flows of the projected, and the financier will usually look to minimize the occurrence of the events that will affect these cash flows. The financial performance of a project will usually affected by four factors, the first being the risk of the project not being completed on time, within budget or failing7 (McKevitt and Xianhai, 2012). The financier will want to know whether the project timeline will be followed, the allocated budget will be utilized and whether the project will be completed according to expectations. This ensures that the project finance is repaid when the project is completed. The second factor that affects the bankability of the project is whether the project will be operational at full capacity when completed. The lender will assess this factor since, as already stated; the finance will only be repaid through the operation of the project. The lender will want to ensure that the operation of the project is at full capacity to ensure the repayment of the funds. The third risk factor determined by the lender is whether the project will be able to generate sufficient funds to cover the cost of the loan. Since the funds are repaid though the performance of the final project, the lender will want to ascertain whether the project will generate sufficient cash flows to service the extended loan. Finally, the project financier will want to ascertain whether the project will be operational for a time needed to completely service the loan8. The financier will analyze the project to assess the risk of it coming to a premature end and not repaying the loan in full. The minimization of the risks mentioned above usually involves a three-step process taken by the financier of the project. The lender first identifies the risks that might affect the bankability of the project, followed by an allocation of the risk among all the parties to the project, and finally a creation of a mechanism for managing the risks associated with the project. The bankability of a project dictates that, if the risk of the project cannot be minimized, the lender will have to include it in the interest margin for the extended loan. Risk identification and analysis The project lender will first consider a feasibility study for the project being conducted to determine its risk factors and the repayment mechanisms9. The financier of the project will review the feasibility study conducted and will usually engage the services of external experts to supplement the feasibility study conducted by the project manager. The feasibility study and the subsequent review will usually focus on whether the project costs have been correctly determined and whether the expected cash flows from the project have been correctly estimated. This will help the financier determine whether the project will be able to cover the cost of finance when it is operational. Some of the risks of the project will be analyzed using different financial models to determine the expected cash flows of the project and its expected life, which are two of the most important factors in the feasibility study. The ability of the project to meet repayment schedules is determined from the feasibility study, and the project financier will usually adjust for changes in market behavior. Since the project is usually long-term in nature, the project financier will consider different market scenarios, for example, the economic variables and regulatory influences or changes. Some of the economic variables that are studied include inflation, interest rate changes, resource prices and their changes, and he influence of exchange rates on the project. Risk allocation Once the project financier and the associated parties have ascertained the risks of the project, the risks are then allocated to the parties most capable of bearing them. Ideally, the project financier and stakeholders will allocate the risks of the project to the parties in the best position to manage, control and mitigate the risk10. The allocation of the risk also depends on the financial ability of the party chosen to bear the associated risk of the project. From practice, the project financier will usually spread uncontrollable risk widely to ensure that the mitigation process is spread out among the stakeholders11. For example, commercial risk is usually allocated to the private parties in the agreement and political and legal risks to the government or public sectors in the region of operation. Risk management Risk management refers to the process of minimizing the probability of occurrence of a risk event and the minimization of the consequences if the risk event actually occurs. In project finance, the financiers of a project need to ensure that for every increment in risk that they bear with the project, the information that they have is also increased and by consequence, the control over the project. Since the project financier has overall security of the project, they must have the responsibility for the financial loss if the borrower or the project commissioner defaults. This ensures that the financier monitor he project closely to ensure that the project is done according to expectations. The close monitoring of the project is done by the financer by imposing certain rules and regulations on the borrower, ensuring that constant reporting is done, and imposing necessary controls over project financial accounts. Despite the end result of these controls, they might cause some measure of inflexibility between the measures and the autonomy required by the borrower. Types of risks As stated by Vinter12, what is an acceptable balance of risks for one project may not be acceptable for another project with slightly different strengths and weaknesses, which indicates that different projects usually have differed levels of risks. In project finance, every project is different and the risks associated with the projects are usually different, but the main risks common to all projects usually involve the ones discussed below. From Vinter’s13 statement, it is understood that major risks fro one project might be relatively minor for another project, but there are risks that are most common to project finance. This part will discuss the se risks and the possible mitigation strategies that a project lender will consider as a means of increasing the bankability of a project. The categorization of risk factors is usually done according to the phase of the project in which the risk might arise. Consequently, the three main categories of risk are the commercial risks, operational risks and legal or political risks. 1. Commercial risk a. Market risk The first instance of commercial risk is evident from the marketability of the final product of the financing project14. This means that the project financing can only be repaid if the product at the end of the process can be turned into profitable cash flows. Therefore, market risk refers to the probability that a buyer for the product will not be found at a price sufficient to return the cash flows necessary to repay the investment in the project. This risk is common to many major projects, and as a way of mitigation, the project financier will usually require the borrower to enter into a forward sales contract with a buyer at an acceptable rate. This ensures that, before the project commences, the financier is assured of cash flows at the end of the project-financing period. b. Currency risk The other commercial risk that faces projects in project finance is the risk facing the currency being used in the transaction15. The first instance of currency risk is that depreciation in the currencies used for the loan will increase the costs of construction or completion of the project. This happens since the resources needed to complete the project will escalate in price. This especially happens when the resource for the project are imported or sourced from an external supplier. The other currency risk occurs when depreciation in the revenue currency depreciates the expected cash flows from the project. Project financiers usually take three strategies in mitigating currency risk, the first being the matching of sales and supply contracts as much as is possible. This ensures that fluctuation in either denomination does not affect the project too severely. The second way of mitigating this risk is by denominating the forwarded financing in the most current foreign currency, which ensures that there are minimal fluctuations in the prices of the loan. The last method is by ensuring the borrower enters into acceptable foreign hedging contracts to minimize the risk of loss through foreign currency depreciations. c. Credit risk The other form of commercial risk is credit risk, where the financier questions whether the borrowers have the resources necessary to manage the completion of the project16. The financier will want to ascertain whether the borrower has sufficient expertise to complete the project and resolve any problems that may arise from the project. Credit risk assessment is also important for the guarantee provided by the borrower that the project will be completed17. In the mitigation process for credit risk, the financier needs assurance that the borrower has the necessary human resource to complete the project, sufficiently trained personnel, experience and has the financial capacity to prop a failing project. The last aspect means that the project financier needs assurance that, if the project is failing, the borrower has the capability to inject more funds to save the project. 2. Operational risk Operating risks refer to the general risks that may affect the performance of a project by ensuring that the costs of the project are increased beyond projections or by ensuring that the project is not completed according to expectations18. Operating risks also affect the ability of the project to continue generating planed outputs and cash flows over the proposed life of the project. Operating risks include but are not limited to the availability of resources and labor, inefficiencies in the provision of labor and lack of technical capability. The financier will always try to minimize operating risks by ensuring that the operator is reputable, financially sound, and is covered by sufficient performance bonds19 (Arowolo, 2005). During the loan period, the financier can manage operating risk by requiring the provision of constant reports that detail the operation of the project, and by controlling the cash flows from the project. The cash flows from the project are controlled by insisting tat the proceeds are paid into regulated accounts to be used for specific costs. a. Construction risk The biggest part of the project being financed is the completion process, where the cash flows can only be realized if the project is completed20 (Jeffrey, 2009). This phase of the project usually carries the highest risk for the financier since there is the danger that the project will not be completed on time or the budget will be exceeded. The budget could be exceeded by the project because of the technicalities of the project, the labor required and construction complications. These kinds of delays or increases in costs might delay the repayments of the loan and cause the interest of the finance to increase exponentially or the debt to accumulate to unsustainable levels. The increase in completion time might also destroy project purchase hopes and the provision of raw materials for the completion of the project. As a means of mitigating these risks, the project financier will usually require the borrower to provide guarantees that they will pay all debts and associated damages if the project is not competed by the stated time. Another mitigation strategy is done by ensuring that the borrower also has sufficient financial commitment in the project, which ensures that the borrower remains committed to the project to avoid losing their investment. This mitigating strategy is done by forcing the borrower to expend some form of equity in the project. The financier could also mitigate this risk by insisting on the development of the project by fixed-price and fixed-time contracts. This is doe by using reputable contractors who have previously completed similar projects, are vouched for by reputable third parties and complete sufficient performance contract bonds. The last mitigation strategy is the use of independent expert reports on the project construction and completion process. The project financier will manage construction and completion risk by ensuring that the funds for subsequent phases are released only when previous phases have been completed and certified by experts. This ensures that the construction is being done as planned and set out in the performance contracts. b. Resource risk Resource risk applies to all projects, since there is the probability that the inputs to the project will be inadequate to provide an appropriate return for the project financier21. For example, in a project for the construction of a toll road in a developing country, there is the risk that there will be insufficient vehicles for the construction. The main methods taken by the project financier to mitigate resource risk includes the use of expert reports to ascertain the availability of inputs for the project. This is done by the financier to ensure that the borrower does not inflate the resource report. For example, for the completion of a project, the project financier will rely on the report of reservoir and engineering reports quantify all the resources needed for the project and quantify the resources available and where the extra resources can be found. The financier could also rely on statistics that display the estimated use of the final project. The second strategy for the mitigation of resource risk is requiring mandatory contracts for the supply of resources as a strategy against price fluctuations in the construction phase. The financier of the project could also mitigate the resource risk by requiring the regulatory authorities to provide guarantees that some minimum level or resources will be provided for the project. c. Technical risk Technical risk refers to the risk that some technical difficulties will arise in the construction or project implementation phase22 (Fritzsche, 2009). The technical risks also include the defects that may affect the plant and equipment being used for the project. This type of risk is usually mitigated by the financier by preferring the use of experienced technology to new an untested technology. This ensures that the risk of failure is controlled or expected from previous experience. The use of expert analysis before the project begins also helps in the reduction of technical risk. During the process implementation phase, technical risk is mitigated by requiring the borrower to set side a sum of the money forwarded to help in the management of technical applications in the project. 3. Legal and political risk a. Regulatory approval risk In the completion of any project, there are regulatory features that need to be completed, including the attainment of government licenses and approvals. Therefore, in project finance, there is the risk that the approvals and licenses required for the project ill not be issued or they will be issued subject to harsh conditions23. Other risks include the risks of excessive taxation, unnecessary royalty payments, or restriction on local distribution and sale. These risks are mitigated by the project financier by ensuring that there is a compliance check before the project begins. This is done by getting expert opinion on compliance with existing laws and regulations in the area of operation. b. Political risk Political risk refers to probability of political instability in the region of operation of the project. Political risk is caused by various events including insurrections, regime changes, coups, strikes and suspension of foreign exchange polices24. Political risk also encompasses the risk that the government under which the project is being completed avoids contractual basks through the imposition of sovereignty clauses. Despite the challenges faced in mitigating political risks, the project financier could try to get contractual agreements that state that the government will not interfere with the project. The project financier also has to obtain expert opinions on the legal capacity surrounding the project and the enforceability of contractual agreements under political instability. The financier could also source the use of political risk insurance bodies, which insure the project against the risk of political instability. Political risk can also be hedged by getting the financiers from different countries, different financial institutions and using agencies that deal with financing across countries. The last way of mitigating political risk is by establishing revenue accounts in stable countries, which ensures that revenues are not affected by political instability. The best example of a case concerning the political risk of undertaking a project is the case of the construction of the Eurotunnel, where the company, The Channel Tunnel Group Limited, sued the governments responsible for the project for not undertaking its duty25. In its arbitration, The Channel Group stated that the governments had failed to prevent immigrants from using the tunnels, and therefore, caused financial trouble to the company. c. Force majeure risk The last aspect of risk that affects the bankability of a project is force majeure risk, which refers to the factors that render the completion of a project impossible. These kinds of risk encompass natural disasters that render the project impossible to complete. Force majeure risks include the risk of flooding or destruction by fires, earthquakes, hurricanes and other natural disasters. The financiers will try to mitigate these risks by conducting due diligence that establish the probability of occurrence of these risks26. This means that the financier will analyze the region of the project with respect to past occurrences of the mentioned aspects. The financier then tries to spread the risk by allocating them to various parties in the agreement to the project conclusion. Bankability and Risk Management After an analysis of the risks above, the financier will then decide on the bankability of the project. In this case, the bankability of the project refers to the ability of the project to return sustainable cash flows that cover the cost of the project and help to repay the loans forwarded to the borrower. As earlier stated, every project is different and is subject to different risk factors that affect the bankability of the projects. Vinter27 states that every project possesses different risk factors, and the risk factors mentioned above are an overview of the common risks that affect different projects. The bankability of different projects is affected differently by the risks mentioned above, since different projects are affected differently by these risks. The locations of the projects also affect the bankability of the projects, since some risks are more prevalent in some regions that in other regions. Therefore, the concept of bankability has to be analyzed with respect to the region of the project, the type of project and the financing method being used by the financier. Conclusion After an analysis of the above risk factors, it is evident that the financier of a project has to consider different risk factors for different projects when extending a loan. The bankability of a project depends on the risks of whether the loan will be repaid, and a lender will have to consider the three classes of risk when deciding on the financing mechanism for a project. Since project finance usually leans on major projects, the loss of financing because of inadequate analysis of bankability is likely to adversely affect the financier. The mechanisms of risk mitigation mentioned above will apply to most projects, but with the prevalence of risk for different projects, the financier will decide on different mitigation strategies. Some projects are susceptible to different risks, and some risks will not apply to some projects. Therefore, the lender ill have to analyze the project and decide the risks that might affect them. Read More