F. Project Finance Specialist Module

Project Finance Specialist Module
Before we get started – what is this

Specialist Module (… and what it is not)
This module is … This module is not …
• an exhaustive and complete list

• An introduction to the financial of all project finance benefits and
concept of Project Finance challenges
• a tool to enable cost-benefit • a scientific study comparing
analysis of project finance different financing methods and
proposing “one best” method
• hands-on and suitable for
capacity-building initiatives • applicable to all countries
without reflection of local
• Builds on concepts (such as NPV conditions
and IRR) covered in other learning
materials of this series. • a blueprint for corporate finance
vs project finance
2
Learning objectives
1. Who are the relevant players in project finance?

2. What is project finance?
3. How is project finance different from on-balance-sheet financing?
4. How are returns and risk aggregated across projects?
5. What is contamination risk?
Overview of what will be covered
1 What is Project Finance and Who are the relevant players?

2 Differences between PF and normal financing
2A Cost of Capital
2B Contamination and Diversification
2C Improved total payoffs
2D Conflict between equity and debt
3 Risk and complexity
4 Risk Management
4A PF as risk management
4B Risk management within PF
5 PF and Joint Ventures
6 Short examples
7 Examples and cases
4

2A Cost of Capital
4 Risk Management
6 Short examples
5
1
What is Project Finance?
Project Finance involves a corporate sponsor

investing in and owning a single purpose,
industrial asset through a legally
independent entity financed with non-
recourse debt.
Source: Harvey, C. et al. (2006) [PowerPoint slides] 6

1
Who are the relevant players?
7
1
Who are the relevant players: Sponsors
Sponsors Description
Industrial sponsors with PF  These firms want to use PF to extend their value chain activities (upstream or
linked to core business downstream), but want to minimize risk
 Public-private-partnership (PPP) is used to involve private capital to reach a

social welfare goal
 Build, operate, transfer (BOT) contracts: A private firm is in charge of building and operating a facility for a
Public sponsors with social while, then the facility is transferred to a public entity
welfare goals  Build, own, operate, transfer (BOOT) contracts: In addition to BOT, here the private entity also owns the
facility for a while
 Build, operate, own (BOO) contracts: In this case, ownership is not transferred to a public entity
Sponsors who develop,

 These players contribute equity to sell their skills in building or running a plant
build, and run the plant
 These firms (often investment banks) are looking exclusively for profitable
Financial investors investments
8
1
What is Project Finance?
A project finance deal has five peculiarities:
• The project company is legally and financially independent from the sponsors
• Debtors have very limited or no recourse to the sponsors in the case of cash
flow shortfalls etc.
• Project risks are allocated equitably among all parties involved (different risk
profiles than usually for debt vs. equity)
• Cash flows generated from the project must be sufficient to cover operating
expense AND debt service. Only after those payments funds flow to sponsors.
• Collateral to lenders is often the asset created in the project
9
1
A typical contract structure of a PF deal
Several roles are sometimes taken on by a single player
Legend:
• FSA (Fuel Supply Agreement)
• RMSA (Raw Material Supply Agreements)
• O&MA (Operations and Maintenance Agreement)
• TKCC is Turnkey Construction Contract (build the plant)
Source: Figure 1.2 in Gatti (2008) 10

1
Why would a someone do this?
PF sounds like a bad deal for both sponsors and lenders

• Creating a new entity, a special purpose vehicle (SPV), is costly
• Monitoring cost is high
• Lenders get no recourse and have to get involved in management
So, why do it?

• Because risk allocation is direct, debt-to-equity ratios can be higher in PF
than in normal investments.
• This allows you to have high debt-ratios, but maintain low risk
• Sponsors do not have to take on the full risks of non-performance because
of the non-recourse clause
• This means that a sponsor firm‘s overall cost of capital remains
untouched
11

2A Cost of Capital
4 Risk Management
6 Short examples
12
2 NOT EXHAUSTIVE
Differences between PF and normal financing
Source: Table 1.1 in Gatti (2008) 13

2A
Cost of Capital
Normally, the cost of capital for a new project depends on existing investment
projects and how they are financed
requity = cost of equity
rdebt = cost of debt
𝐸 𝐷 E = market value of the firm's equity

D = market value of the firm's debt
𝑊𝐴𝐶𝐶 = 𝑟𝑒𝑞𝑢𝑖𝑡𝑦 ∙ + 𝑟𝑑𝑒𝑏𝑡 ∙ ∙ (1 − 𝑇𝐶 ) V = E + D = total market value of the firm’s financing (equity and debt)
E/V = percentage of financing that is equity
𝑉 𝑉 D/V = percentage of financing that is debt
Tc = corporate tax rate
Investors usually consider the following when pricing new capital :
Problems arise:
1. How sound is the project? 1. If the new project is large compared to firm size
2. How sound is the company 2. If risk in the new project is substantially higher than in the
realizing a project? firm average
3. If there is a strong link to existing firm activities (lack of
diversification)
14
2A
Cost of Capital
The return on two projects (A and B) is straightforwardly computed as

the weighted average of the two returns:
𝑅𝑂𝐼𝐴 ∗ 𝑠𝑖𝑧𝑒𝐴 𝑅𝑂𝐼𝐵 ∗ 𝑠𝑖𝑧𝑒𝐵

𝑟𝐴+𝐵 = +
𝑠𝑖𝑧𝑒𝐴 + 𝑠𝑖𝑧𝑒𝐵 𝑠𝑖𝑧𝑒𝐴 + 𝑠𝑖𝑧𝑒𝐵
What is the return on a portfolio of two projects, where project A has a

value of 1,000, project B a value of 4,000, The ROI on A is 10% and the
ROI on B is 20%?
15
2A
Cost of Capital
What is the return on a portfolio of two projects, where project A has a

value of 1,000, project B a value of 4,000, The ROI on A is 10% and the
ROI on B is 20%?
0.1 ∗ 1,000 0.2 ∗ 4,000

𝑟𝐴+𝐵 =
1,000 + 4,000
+
1,000 + 4,000
= 0.18
16
2B
Contamination risk and diversification
If the three issues covered in page 14 come together, a special complication arises:
The risk underlying the portfolio (σA+B) of the two projects is more complicated. The risk
depends on the correlation between the two projects (ρAB) and the wA and wB are the
weights (relative size of the projects e.g. 20% and 80%)
𝜎𝐴+𝐵 = 𝜎𝐴2 ∙ 𝑤𝐴2 + 𝜎𝐵2 ∙ 𝑤𝐵2 + 2 ∙ 𝜎𝐴 ∙ 𝑤𝐴 ∙ 𝜎𝐵 ∙ 𝑤𝐵 ∙ 𝜌𝐴𝐵
What is the risk on the portfolio (project A has a value of 1,000, project B a value of 4,000),
the risk of A is 5% and the risk of B is 20%, and correlation is zero?
𝜎𝐴+𝐵 = 52 ∗ 0.22 + 202 ∗ 0.82 + (2 ∗ 5 ∗ .2 ∗ 20 ∗ .8 ∗ 0)
17
2B
If the new project is heavily related to existing firm activities. Risk increases as correlation increases
• Return rises from 10% to 18% in all cases.
• Risk, however, rises in all cases (from 5%), depending on correlation to 15% to 17%.

2B
Even in the best case of portfolio diversification*, when

correlation = -1 (the project actually adds to
diversification) risk overall increases (from 5% to 15%).
This is contamination risk.
• As a consequence, the cost of capital to refinance the company
if e.g. debt matures will be substantially higher.
• This effect naturally is dependent on the relative size of the
new project to the old one.
• The effect can be reinforced by related projects.
If the increase in risk leads to an increase in average cost of capital greater than the increase in ROI, the project
reduces firm value.
• That is (one reason) why projects get financed off balance sheet
*does not necessarily mean this is the best case overall for every investor
19
2C
Improved total payoffs
There are two financing scenarios and

six performance scenarios in this table
• The company defaults in scenarios 1, 2, and
3 under solution 1 (on-balance-sheet)
• Project B is in default in scenarios 1, 3, and
5 under solution 2 (off-balance-sheet).
However, the company only defaults in
scenarios 1 and 2.

2D
Conflict of interest between equity and debt
• In scenario 2, project finance is optimal

because it avoids the contamination of project
B from project A. Project B survives.
• In scenario 3, project finance is still optimal,
because A survives while B defaults because
contamination is avoided.
• In scenario 5, project finance is still optimal
from shareholders’, but not from debtholders’
position. Cash flows from A would have been
sufficient to avoid default in project B.
• Not using coinsurance, value was redistributed
from bondholders to shareholders


2A Cost of Capital
4 Risk Management
6 Short examples
22
3
Why are we discussing risk and complexity?
• As we briefly discussed previously, Project Finance grants you the

ability to directly allocate risks. This makes this type of financing
particularly suited for rather large, complex, and/or risky projects.
23
3 NOT EXHAUSTIVE
Common risks in complex projects
• Complexity is not easy to manage

• Different kinds of complexity:
• Technical complexity
• Social complexity
• Complexity is amplified by
• Large scale and scope of international projects
• Different, ambiguous, and interconnected tasks
• Technology is new and functionality is hard to predict
• Substantial number of project participants including the public attention
24
3 NOT EXHAUSTIVE
Underestimation of project related features such as costs, delays, contingencies and changes in quality,
price, project specifications, designs, exchange rates, and external environmental factors
Demand prediction failures due to methodology weaknesses, poor databases, unexpected changes, and
the effect of appraisal bias
Complexity
leads to Conflict of interests
Opportunistic behavior by stakeholders
Despite all of these risks, it is unlikely that a project will be cancelled. Why?
Source: Kardes et al. (2013) p. 6-7 25

3 NOT EXHAUSTIVE
Because of the following reasons:
Illusion Tendency to underestimate complexity. A manager’s misinterpretation of her

management ability or her power to influence outcomes of the project leads to
underestimation of risks and overvaluation of positive information.
of The ‘‘Illusion of control’’ pitfall arises often due to the high degree of uncertainty
which leads to an inherent difficulty in forecasting. Thus, the greater the
control uncertainty, the greater the perception of control and level of overconfidence
which leads to a higher probability of underestimating the risks.

3 NOT EXHAUSTIVE
Sunk Deeper into a highly visible project, partners have invested more money and time
eventually reaching a point of no return. The risk of being viewed as unsuccessful
and wasteful, puts at risk credibility and positions of decision makers. They then
cost escalate their commitment to avoid criticism or loss of reputation.
Consider the following situation:
effect When 85% of your project for a radar-blank plane is completed to be $15 million,
another firm begins marketing a plane which is much faster and far more
economical than the plane your company is building. The question is: should you
invest the last 15% of the research funds to finish your radar-blank plane?’’

3 NOT EXHAUSTIVE
Decisions Individuals are more risk-seeking in order to avoid negative outcomes

than they are risk-avoiding to obtain positive outcomes. This means they
are willing to take more risks to avoid the negative consequences of
under risk failed projects.
Risk seeking behavior arises, and to continue to invest in the failed
project in hope of future gain is more likely to happen than total
withdrawal.
For example, once $100 million has already been spent in an
unsuccessful project, taking an additional risk on an additional $10
million is not perceived so risky.

3 NOT EXHAUSTIVE
Self- This theory also provides an explanation for escalating

commitment of managers – the tendency of decision makers to
stick with a failing course of action.
justification Individuals might be unwilling to admit wrongdoing. Therefore,
they justify their behavior and avoiding negative feedback.

3 NOT EXHAUSTIVE
Managerial recommendations for complex projects
Trained Training ensures new technology is used effectively and reduces resistance to change.
workforce Managers and employees should possess the skills and knowledge to use the necessary
technology for a complex project.
Clear goals Managers can avoid disagreements that might distract from the already complex project.
Management should allocate time to clarification of goals and interpretations and
revelation of hidden agendas using transparent information flows.
Clear contracts Contracts should clearly define goals, rights and obligations for all partners and sponsors.
They can introduce backup plans for critical elements in the supply chain
Transparency Decrease the risk of overestimating manager competence and minimizing project
complexity by using external checks to maintain transparency. Greater transparency,
independent project appraisals, and scrutiny can help overcome the “illusion of control”.
Source: Kardes et al. (2013) p. 10 30

3 NOT EXHAUSTIVE
Managerial recommendations for complex projects
Pay attention to the soft criteria, such as partner and people selection. Detailed knowledge of potential partner’s
Collaboration management culture, strong relationships, effective communication, trust and confidence, cross-cultural
communication, evaluation and monitoring of the relationship quality, and creating a cooperative environment are
necessary to ensure success.
Maintaining lasting mutual interests can contribute to success. Collaborations based on gain-sharing and risk-
Structure sharing. This can mean creating a specific project structure to achieve this - ‘‘sink or swim together’’.
Prior Prior cooperative experience between partners and the reputation of the companies before the partnership are
key determinants of relationship quality.
experience
Balance control and commitment. Too much control increases the possibility of self-serving behavior and distrust,
Balance while lack of commitment can make contributions unforthcoming.
Start out with a viable project idea and thoroughly shape projects during the early stages since most projects have
Shape early little flexibility after start. Investments in the early stages of the project can help alleviate problems and improve
quality. Therefore, cost reduction is secured and better outcomes are achieved
Source: Kardes et al. (2013) p. 10 31


2A Cost of Capital
4 Risk Management
6 Short examples
32
4A
Project Finance as a risk management technique
Risk management involves the following steps:
Risk identification Risk analysis Risk transfer and allocation to actors Residual risk management
• What are the risks? • How high are the risks? suited ensure coverage • What to do if additional risk or uncoverable
• How can risks be collateralized / managed? risks materialize?
In a way, the whole Project Finance setup is designed to distribute risks
Bounded rationality (limitations to individual decision making), makes PF contracts difficult. There need
to be for something a to solve residual issues
33
4A
Risk Contamination
Problems:
• A high risk project can potentially drag a healthy corporation into distress. Short of actual failure, the
risky project can increase cash flow volatility and reduce firm value. Conversely, a failing corporation can
drag a healthy project along with it.
Structural Solutions:
• Through project financing, sponsors can share project risk with other sponsors. Pooling of capital
reduces each provider’s distress cost due to the relatively smaller size of the investment and therefore
the overall distress costs are reduced. This is an illustration of how structuring can enhance overall firm
value.
• Project financed investment exposes the corporation to losses only to the extent of its equity
commitment, thereby reducing its distress costs.
• Co-insurance benefits are negative (increase in risk) when sponsor and project cash flows are strongly
positively correlated. Separate incorporation eliminates increase in risk.

4B NOT EXHAUSTIVE
Risk management within PF
1. Risk retention
• Corporate finance: if the project is on-balance-sheet, and does not perform, cashflows from other
projects can be used to compensate the shortfalls
• Project finance: only one source of revenue
2. Transfer risk to one of the counterparties

• In PF, specialized counterparties take on the risk they are best able to deal with
• This is essentially their business risk, dealing with which is (one of) their core competency(ies)
3. Transfer risk to a specialized insurer
• Some risks are too remote to be taken on by a counterparty to the contract
• These are transferred to insurers (or specialized banks)
35
4B
Risk allocation in PF project phases
Legend:
EPC: Engineering, Procurement, and
Construction
O&M: Operations and Maintenance

4B
EPC contracts as risk management tools
Engineering, Procurement, and Construction (EPC) agreements transfers construction risk to the constructing entity
Constructor guarantees completion date, cost of the works, and plant performance
Risk and penalties
Additional risk (like interest rate or exchange rate) is Penalties for non-delivery of the constructor or
covered by specialized entities subcontractors are less than project value
In reality, there is no true “guarantee“ for turnkey completion

Renegotiation and refunds for missed revenues are put
Lending banks are involved in the renegotiation process
in place
37
4B
Risk allocation in PF project phases
Legend:
EPC: Engineering, Procurement, and
Construction
O&M: Operations and Maintenance

4B
Put or pay agreements protect from supply risk
You can draft contracts for unconditional

supply:
• In these accords, the supplier sells the SPV

preset volumes of input at pre-agreed
prices.
• If supply is lacking , normally the supplier is

required to compensate for the higher cost
incurred by finding another source of input
Source: Figure 3.5 in Gatti (2008)

39
4B
O&M agreements allocate operational risk
Operations and Maintenance (O&M) agreements allocate operational risk to the contractor
in charge of running a facility
• Fixed price contract: the operator assumes the risk of fluctuating operating cost
• Pass-through contract: the SPV pays performance bonuses to the operator depending on plant
efficiency

and Figure 3.7 in Gatti (2008)
4B
Offtake agreements limit market risk for the SPV
Mitigating market risk through offtake

agreements can make use of good credit
ratings of buyers (in infrastructure, these are
often national governments)
• In these contracts, prices are fixed in relation
to parameters that track e.g. inflation
• They work similarly to put or pay agreements


2A Cost of Capital
4 Risk Management
6 Short examples
42
5
How project finance fits in with JVs
PF must consider the country risk and the market and/or

technological risk. It can be used in situations:
• When both risks are low (quartile II),
• When country risk is high but market and/or technological
risk is low (quartile I)
• When country risk is low but market and/or technological
risk is high(quartile III)
A JV can minimize exposure to risk when both, country risk

and market and/or technological risk, are high (quartile IV)

5
How project finance fits in with JVs: Political Risk

Risk Solution
Political and • External accounts for proceeds
Sovereign Risk • Political risk insurance (Expensive)
• Export Credit Guarantees
• Contractual sharing of political risk between lenders and external project
sponsors
• Government or regulatory undertaking to cover policies on taxes, royalties,
prices, monopolies, etc
• External guarantees or quasi guarantees
• Externalizing the project company by forming it abroad or using external law
or jurisdiction


2A Cost of Capital
4 Risk Management
6 Short Examples
45
6
Example: Poland’s A2 Motorway
Background: AWSA is an 18 firm consortium with concession to build and

operate toll road as part of Paris-Berlin-Warsaw-Moscow transit system. It is
seeking financing for the € 1bn deal (25% equity). It is being asked to put in
additional € 60-90m in equity. Concession due to expire in 6 weeks.
Key Issues:
• How to assess the project risk and allocation of risks.
• How can project the project be structured to best manage risk?

6
Example: Poland’s A2 Motorway
Construction Risk: Operating Risk:

•Best controlled by builder and government. •Best controlled by AWSA and the operating company.
•Fixed priced turnkey contract with reputed builder. •Multiple analyses by reputable entities for traffic volume and
•Government responsible for procedural delay risk and support revenue projections.
infrastructure. •Update: in 2018, AWSA had to return approx. EUR 450m of
•Insurance against Force Majeure, adequate surplus for undue state aid due to basing the calculation on the outdated
contingencies. forecasts of traffic volume.
•Comprehensive insurance against Force Majeure.
•Experienced operators, road layout deters misuse.
Political Risk: Financial Risk:

•Best controlled by Polish Government and AWSA. •Best controlled by Sponsor and lenders.
•Assignment of revenue waterfall to government: Taxes, lease and •Contracts in € to mitigate exchange rate risk.
profit sharing. •Low senior debt, adequate reserves and debt coverage, flexible
•Use of UK law, enforceable through Polish courts. principle repayment.
•Counter guarantees by government against building competing •Control of waterfall by lenders gives better cash control.
systems, ending concession. •Limited floating rate debt with interest rate swaps for risk
mitigation.

6
Case : The Chad Cameroon Project
Background: An oil exploration project sponsored by Exxon-Mobil in Central Africa with

two components:
1. Field system: Oil wells in Chad, cost: $1.5bn.
2. Export System: Pipeline through Chad and Cameroon to the Atlantic, cost: $2.2bn.
Key Issues:
• Chad is a very poor country ruled by President De’by, a “warlord”. Expropriation risk.
• Possibility of hold up by Cameroon.
• Allocation of proceeds – World Bank’s role and Revenue Management Plan.

6

Possible financing Strategies for Exxon-Mobil
Financing Options Field System Export System Total Investment
Corporate Finance: $1521m $322m+$1881m=$220 $3723m

1 sponsor, EM 100% owner 3m
Corporate Finance: 40%* 40%*($2203m) = $1489m

3 Sponsors, EM 40% Owner $1521m = &608m $881m
Hybrid structure: Corp. Finance Project Finance $929m
3 Sponsors, EM 40% owner 40%* 40%*(123+680)=
$1521m = $608m $321m
Project Finance: 16%*$1521m = 16% * ($2203) $596m

3 sponsors D/V=60% $243m =$352m
EM 40% Owner

6
Structural choice: Hybrid structure

• Brings in the World Bank to address the issue of Sovereign Risk.
• Exxon-Mobil chooses corporate finance for oil fields since investment size is
small. Other means of managing sovereign risk.
• Exxon-Mobil chooses project finance for the pipeline to diversify and mitigate
risk.
• Involves the two nations to prevent post opportunistic behavior with the export
system.

Conclusions
• Project finance involves many different parties, each balancing their own
interests
• Project finance can protect company’s assets, even if the project is not
successful
• Project finance allows for higher debt levels
• Project finance can be used to manage complex projects
• There is a strategy to manage almost every kind of risk…
• Contamination risk can be avoidable by using project finance
• Project finance requires extensive contracting and lots of communication
51

2A Cost of Capital
4 Risk Management
6 Short examples
52
AES case study
Can be purchased at:

https://hbsp.harvard.edu/product/204109-
PDF-
ENG?Ntt=aes+capital+budgeting&additionSou
rce=Item+Detail+Page&dialog=teaching-
note&itemFindingMethod=Search&parentProdu
ctId=204109-PDF-ENG
53
General question structure
The past: What does the firm do and how did we get to the problem?
The present: What is the problem?
The suggestion: How does the case suggest to solve the problem?
The evaluation: What does the suggestion imply, particularly regarding the past?
Where would we be if we had followed the suggestion in the past?
The analysis: What do we get if we apply the suggestion to an element in the case
Take aways: Key learnings and relate the case back to other class materials
54
Questions for the case report
• Case reports have to answer the following questions:
1. How would you evaluate the capital budgeting method used historically by
AES? What‘s good and bad about it?
2. If Venerus implements the suggested methodology, what would be the range
of discount rates that AES would use around the world?
3. Does this make sense as a way to do capital budgeting? How do the underlying
assumptions under the new methodology differ from the old ones?
4. What is the value of the Pakistan project using the cost of capital derived from
the new methodology? If this project was located in the US, what would its
value be?
5. How does the adjusted cost of capital for the Pakistan project reflect the
probabilities of real events? What does the discount rate adjustment imply
about expectations for the project because it is located in Pakistan and not the
US?
55
AES’s business and its historic approach to
capital budgeting
56
AES‘s business and history
• What was AES‘s original business and how did it change?

• Originally domestic US firm
• Liberalization in many countries led to FDI being possible
• Now four business units
• Contract Generation
• Competitive Supply
• Large Utilities
• Growth Distribution
57
AES‘s business and history
• How did inflows and outflows of cash change at AES?
Revenues Costs
1980s
AES
Revenues Costs
2000s
AES
58
Capital budgeting at AES (historically)
• What were the key principles to capital budgeting at AES

• All flows are equally risky
• All non-recourse debt deemed good
• Discount rate of 12% for all projects
• Did this make sense in the past (1980s)?

• (see figure before)
• Plants or utilities in Pittsburg, Indiana, Texas
• Predictable US Dollar revenues (regulated industries)
• Reasonable to assume equal risk
59
Capital budgeting at AES (historically)
• What were the key principles to capital budgeting at AES

• All flows are equally risky
• All non-recourse debt deemed good
• Discount rate of 12% for all projects
• Does this make sense in the later 1990s and after?

• Geographic diversification means new risk
• Different risks for different businesses
• Different exchange rates
60
The new methodology for determining discount
rates
61
Capital budgeting at AES (proposed)
• What is the new methodology supposed to accomplish?

• Different discount rates for different investments
• Country risk and other risk to be considered in discount rates
• We are going to get different adjusted WACCs for the projects
𝐸 𝐷
𝑊𝐴𝐶𝐶 = 𝑟𝑒𝑞𝑢𝑖𝑡𝑦 ∙ + 𝑟𝑑𝑒𝑏𝑡 ∙ ∙ (1 − 𝑇𝐶 )
𝑉 𝑉
• We will go through the updated methodology using the Lal Pir

project
62
• The cost of equity

𝐸 𝐷
• What is unlevered equity beta? 𝑉 𝑉
• conceptually?
• the beta for an equity-financed project
• for the Lal Pir project?
• 0.25 (E7b)
• What is the levered beta for the Lal Pir project given the target capital structure?
𝛽𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 0.25
𝛽𝑙𝑒𝑣𝑒𝑟𝑒𝑑 = = = 0.38
𝐸 0.65
𝑉
• What does it mean to use US-based comparables here?
63
• The cost of equity 𝑊𝐴𝐶𝐶 = 𝑟𝑒𝑞𝑢𝑖𝑡𝑦 ∙

𝐸 𝐷
+ 𝑟𝑑𝑒𝑏𝑡 ∙ ∙ (1 − 𝑇𝐶 )
𝑉 𝑉
𝑟𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑟𝑓 + 𝛽 𝑟𝑀 − 𝑟𝑓 = 0.045 + 0.38 ∗ 0.07 = 0.072 = 7.2%
• What does this mean?

• This is a baseline cost of equity for Lal Pir, pretending it is in the USA.
• How do we adjust for the project being in Pakistan?
• We add the sovereign spread (9.9%). This is the difference between the risk-
free rates.
𝑟𝑒𝑞𝑢𝑖𝑡𝑦 (𝐿𝑎𝑙 𝑃𝑖𝑟) = 0.072 + 0.099 = 0.171 = 17.1%
64
• The cost of debt 𝐸 𝐷

𝑉 𝑉
𝑟𝑑𝑒𝑏𝑡 = 𝑟𝑓 + 𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝑆𝑝𝑟𝑒𝑎𝑑 = 0.045 + 0.0357 = 0.0807 = 8.07%
• What is the intuition behind this approach?

• The cost of debt reflects the risk-free rate plus the default spread
• This is again assuming the project is in the USA.
• How do we correct for the project being in Pakistan?
• We again add the sovereign spread
𝑟𝑑𝑒𝑏𝑡 (𝐿𝑎𝑙 𝑃𝑖𝑟) = 0.0807 + 0.099 = 0.18 = 18%
65
• The project‘s idiosyncratic risk
• How does the risk assessment work?

• Risks are defined and weighted
• Risk scores (between 0 and 3) are allocated Category
Operational
Weight
3.5%
Score
• Risk score is mapped to 0 to 1500 bps risk premia Counterparty 7.0% 1
Regulatory 10.5% 2
Construction 14.5% 0
• What is the risk score for Lal Pir?

Commodity 18.0% 1
Currency 21.5% 2
• The risk score is 1.4 Legal
Risk Score
25.0% 2
1.4
• The risk adder is 7.0% Risk Adder 7.0%
66
• Computing the adjusted WACC (IRM = Idiosyncratic Risk Measure)

𝑊𝐴𝐶𝐶𝑎𝑑𝑗𝑢𝑠𝑡𝑒𝑑 = 0.171 ∗ 0.65 + 0.18 ∗ 0.35 ∗ 1 − 0.23 + 0.07 = 0.23 = 23%
• What is the Lal Pir project value at the Lal Pir discount rate?
• $277.52
• What is the Lal Pir project value at the Red Oak discount rate (6.5%)?
• $730.34
67
What is the range of discount rates?
• How you compute the highest and lowest adjusted WACCs?
Lowest = Red Oak = 9.7%

Highest = Andres = 29.9%
68
Evaluating the new methodology
69
Capital budgeting at AES (evaluation)
• If you were on the board of AES, what would you say? Does any of
this make sense?
• The idiosyncratic risk measure?

• Little trust in project cash flows
• How will local forecasters react?
• The use of sovereign spreads?

• What risks do sovereign spreads capture?
• How does the different valuation under different discount rates translate into cash flow
probabilities?
• 6.5% vs. 23%?
• How likely is it that Lal Pir will be expropriated in 2009 (or otherwise seize to generate
CFs)?
70
Expropriation in politically unstable countries
• Expropriation means that expected cash flows might not materialize

• The net present value can be changed accordingly
𝐶1 ∗ 𝑆1 𝐶𝑚 ∗ 𝑆𝑚 𝐶𝑚 ∗ (1 + 𝑔) ∗ 𝑆𝑚 𝐺ℎ ∗ 𝑆ℎ
𝑁𝑃𝑉 = 𝐶0 ∗ 𝑆0 + +⋯+ + − 𝑝ℎ ∗
1+𝑟 1+𝑟 𝑚 𝑟−𝑔 ∗ 1+𝑟 𝑚 1+𝑟 ℎ
• We add a (negative) term indicating the discounted value of the expropriated

project (Gh) to our NPV computation. We multiply this value with the
probability that the project will be expropriated (ph).
71
Expropriation of Lal Pir
• If we pretend all this is because of fear of expropriation

• What is the probability of expropriation, say in year 2009?
𝐶1 𝐶𝑚 𝐺ℎ
𝑁𝑃𝑉 = + ⋯+ 𝑚
− 𝑝ℎ ∗ ℎ
1+𝑟 1+𝑟 1+𝑟
730.34
277.52 = 730.34 − 𝑝ℎ ∗ 6
1 + 0.065
𝑝ℎ = 0.905
• Is this a reasonable assumption?
72
A 50% reduction in Lal Pir cashflows
• What if we assume the project only delivers 50% of projected cash

flows (under the Red Oak discount rate)?
𝐶1 ∗ 0.5 𝐶𝑚 ∗ 0.5
𝑁𝑃𝑉 ′ = + ⋯+ = 0.5 ∗ 𝑁𝑃𝑉 = 0.5 ∗ 730.34 = 365.17
1+𝑟 1+𝑟 𝑚
• This is still more than under the “appropriate“ Lal Pir discount rate
(NPV=277.52)
• What do you think?
73
AES and international CAPM
74
Relating this back to previous content
• Why do people adjust discount rates?

• because it seems more sophisticated...
• We can at least cover different types of risks differently (by adjusting

the betas)
• A scenario analysis of different cash flow scenarios may be helpful
• Real option contributions may capture some of the upside potentials

of risk
75
Risk adjustment for cross-border investment (I)
• For integrated capital markets, literature suggests using a world-

market (e.g. MSCI world) for the average return (rWM), computing the
risk relative to this (𝛽𝑊𝑀 ) and adding a country‘s default spread (𝛼𝐶 )
to the cost of capital.
𝑟 = 𝑟𝑓 + 𝛽(𝑟𝑀 − 𝑟𝑓 )
𝑟 = 𝑟𝑓 + 𝛼𝐶 + 𝛽𝑊𝑀 ∙ (𝑟𝑊𝑀 − 𝑟𝑓 )
Source: https://www.msci.com/world
76
A continuum in the degree of integration
Source: Buckley, International Finance (2012)
77
Risk adjustment for cross-border investment (II)
• For non-developed countries, this approach is argued by some

scholars to be insufficient.
• Two ways are proposed to account for additional risk.
1. Exchange 𝛽𝑊𝑀 for the ratio of standard deviation in returns from the
project (𝜎𝑖 ) over standard deviations in returns in the market portfolio
(𝜎�𝑊𝑀). Sometimes, this ratio is simply approximated by 0.6.
2. Add a premium that reflects the country‘s default spread (𝛼𝐶 ) and the
ratio of variability in its equity market (𝜎𝑀𝑖 ) and in government bonds
(𝜎𝐺𝑖 ) to the market risk premium
78
• The cost of equity

𝐸 𝐷
𝑉 𝑉
𝑟𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑟𝑓 + 𝛽 𝑟𝑀 − 𝑟𝑓 = 0.045 + 0.38 ∗ 0.07 = 0.072 = 7.2%
• What does this mean?
• This is a baseline cost of equity for Lal Pir, pretending it is in the USA.
• How do we adjust for the project being in Pakistan?
• We add the sovereign spread (9.9%). This is the difference between the risk-
free rates.
𝑟𝑒𝑞𝑢𝑖𝑡𝑦 (𝐿𝑎𝑙 𝑃𝑖𝑟) = 0.072 + 0.099 = 0.171 = 17.1%
79
The new approach in the context of S2
• The suggested (new) methodology for capital budgeting at AES:

𝑟 = 𝑟𝑓 + 𝛼𝐶 + 𝛽𝑈𝑆 ∙ 𝑟𝑈𝑆 − 𝑟𝑓 = 17.1%
• For integrated capital markets:

𝑟 = 𝑟𝑓 + 𝛼𝐶 + 𝛽𝑊𝑀 ∙ 𝑟𝑊𝑀 − 𝑟𝑓 < 17.1%
• For fairly segmented capital markets:

𝜎𝑀𝑖
𝑟 = 𝑟𝑓 + 𝛼𝐶 + 𝛽𝑊𝑀 ∙ 𝑟𝑊𝑀 + 𝛼𝐶 ∗ − 𝑟𝑓 >? 17.1%
𝜎𝐺𝑖
• For embryonic capital markets
𝜎𝑖
𝑟 = 𝑟𝑓 + 𝛼𝐶 + ∙ 𝑟𝑊𝑀 − 𝑟𝑓 <? 17.1%
𝜎𝑊𝑀
80
In summary
81
The key take aways from the AES case
• Idiosyncratic (micro) risk should not go into discount rates (against

CAPM assumptions)
• Adding risk spreads to the discount rate may double (triple?) penalize
projects
• The resulting valuation spiral might turn problematic
• Stuffing risks into discount rates implies unrealistic (?) probabilities of
expropriation
• This kind of evaluation suggests there is a lot of precision where
really there is not so much
82

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Project Finance Specialist Module

Before we get started – what is this

• an exhaustive and complete list

1. Who are the relevant players in project finance?

1 What is Project Finance and Who are the relevant players?

1 What is Project Finance and Who are the relevant players?

Project Finance involves a corporate sponsor

Source: Harvey, C. et al. (2006) [PowerPoint slides] 6

 Public-private-partnership (PPP) is used to involve private capital to reach a

Sponsors who develop,

A project finance deal has five peculiarities:

Several roles are sometimes taken on by a single player

Source: Figure 1.2 in Gatti (2008) 10

PF sounds like a bad deal for both sponsors and lenders

So, why do it?

1 What is Project Finance and Who are the relevant players?

Source: Table 1.1 in Gatti (2008) 13

𝐸 𝐷 E = market value of the firm's equity

Investors usually consider the following when pricing new capital :

The return on two projects (A and B) is straightforwardly computed as

𝑅𝑂𝐼𝐴 ∗ 𝑠𝑖𝑧𝑒𝐴 𝑅𝑂𝐼𝐵 ∗ 𝑠𝑖𝑧𝑒𝐵

What is the return on a portfolio of two projects, where project A has a

What is the return on a portfolio of two projects, where project A has a

0.1 ∗ 1,000 0.2 ∗ 4,000

Contamination risk and diversification

𝜎𝐴+𝐵 = 𝜎𝐴2 ∙ 𝑤𝐴2 + 𝜎𝐵2 ∙ 𝑤𝐵2 + 2 ∙ 𝜎𝐴 ∙ 𝑤𝐴 ∙ 𝜎𝐵 ∙ 𝑤𝐵 ∙ 𝜌𝐴𝐵

𝜎𝐴+𝐵 = 52 ∗ 0.22 + 202 ∗ 0.82 + (2 ∗ 5 ∗ .2 ∗ 20 ∗ .8 ∗ 0)

Contamination risk and diversification

Source: Table 1.4 in Gatti (2008) 18

Contamination risk and diversification

Even in the best case of portfolio diversification*, when

Improved total payoffs

There are two financing scenarios and

Source: Table 1.5 in Gatti (2008) 20

Conflict of interest between equity and debt

• In scenario 2, project finance is optimal

Source: Table 1.5 in Gatti (2008) 21

1 What is Project Finance and Who are the relevant players?

Why are we discussing risk and complexity?

• As we briefly discussed previously, Project Finance grants you the

• Complexity is not easy to manage

Opportunistic behavior by stakeholders

Source: Kardes et al. (2013) p. 6-7 25

Because of the following reasons:

Illusion Tendency to underestimate complexity. A manager’s misinterpretation of her

Source: Kardes et al. (2013) p. 6-7 26

Because of the following reasons:

Source: Kardes et al. (2013) p. 6-7 27

Because of the following reasons:

Decisions Individuals are more risk-seeking in order to avoid negative outcomes

Source: Kardes et al. (2013) p. 6-7 28

Because of the following reasons:

Self- This theory also provides an explanation for escalating

Source: Kardes et al. (2013) p. 6-7 29

Source: Kardes et al. (2013) p. 10 30

Source: Kardes et al. (2013) p. 10 31

1 What is Project Finance and Who are the relevant players?

Project Finance as a risk management technique

Risk management involves the following steps:

Project Finance: 16%$1521m = 16% ($2203) $596m