Module II:

Project Financing; Project Financing Capital structure, sources of finance Margin money,
promoter‘s contribution, consortium lending and local syndication by banks, financing through
markets and public issues, Term loans and debentures
Project Financing
Project financing refers to the method of funding a specific development or business project
using a structured financial plan. Unlike traditional forms of financing, where a company's
creditworthiness and general assets secure a loan, project financing relies on the project's
anticipated cash flow and assets as collateral. This type of financing is often used for large-scale
infrastructure projects, such as power plants, highways, or mining operations. Project financing is
commonly used for capital-intensive ventures where the project's revenue stream is expected to be
sufficient to repay the financing over time. This approach allows companies to undertake large
projects without significantly impacting their balance sheets and helps distribute risks
appropriately among stakeholders. Project finance is the funding of long-term infrastructure,
industrial projects, and public services using a non-recourse or limited recourse financial structure.
The debt and equity used to finance the project are paid back from the cash flow generated by the
project. Project financing is a loan structure that relies primarily on the project's cash flow for
repayment, with the project's assets, rights, and interests held as secondary collateral.
Project Financing Capital structure
The capital structure of a project financing arrangement outlines how the project will be
financed through combination of equity and debt. It represents the mix of different sources of
funding that will be used to support the development, construction, and operation of the project.
The specific capital structure can vary depending on the nature of the project, the industry, and the
risk profile. Here are the main components of a project financing capital structure:
1. Cost of Project
Conceptually, the cost of project represents the total of all items of outlay associated with
a project which are supported by long-term funds. It is the sum of the outlays on the following:
a) Land and site development
b) Buildings and civil works

c) Plant and machinery

d) Technical knowhow and engineering fees
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 e) Expenses on foreign technicians and training of Indian technicians abroad
f) Miscellaneous fixed assets
g) Preliminary and capital issue expenses

h) Pre-operative expenses
i) Margin money for working capital
j) Initial cash losses
2. Land and Site Development
The cost of land and site development is the sum of the following:
a) Basic cost of land including conveyance and other allied charges
b) Premium payable on leasehold and conveyance charges
c) Cost of levelling and development
d) Cost of laying approach roads and internal roads

e) Cost of gates
f) Cost of tube wells
The cost of land varies considerably from one location to another. While it is very high in
urban and even semiurban locations, it is relatively low in rural locations. The expenditure on site
development, too, varies widely depending on the location and topography of the land.

3. Buildings and Civil Works

Buildings and civil works cover the following:
a) Buildings for the main plant and equipment.
b) Buildings for auxiliary services like steam supply, workshops, laboratory, water
supply, etc.
c) Godowns, warehouses, and open yard facilities.

d) Non-factory buildings like canteen, guest houses, time office, excise house, etc.
e) Quarters for essential staff.
f) Silos, tanks, wells, chests, basins, cisterns, hoppers, bins, and other structures
necessary for installation of the plant and equipment.
g) Garages, Sewers, drainage, etc.

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 h) Other civil engineering works.
The cost of the buildings and civil works depends on the kinds of structures required which,
in turn, are dictated largely by the requirements of the manufacturing process. Once the kinds of
structures required are specified, cost estimates are based on the plinth area and the rates for
various types of structures. These rates, of course, vary with the location to some extent.
4. Plant and Machinery
The cost of the plant and machinery, typically the most significant component of the project
cost, consists of the following:
a) Cost of Imported Machinery: This is the sum of
(i) FOB (free on board) value,
(ii) Shipping, freight, and insurance cost,
(iii) Import duty, and
(iv) Clearing, loading, unloading and transportation charges.
b) Cost of Indigenous Machinery: This consists of
(i) FOR (free on rail) cost,
(ii) Sales tax, octroi, and other taxes, if any, and

(iii) Railway freight and transport charges to the site

5. Cost of Stores and Spares

6. Foundation and Installation Charges

The cost of the plant and machinery is based on the latest available quotation adjusted for
possible escalation. Generally, the provision for escalation is equal to the following product: (latest
rate of annual inflation applicable to the plant and machinery) × (length of the delivery period).
7. Technical Know-how and Engineering Fees
Often it is necessary to engage technical consultants or collaborators from India and/or
abroad for advice and help in various technical matters like preparation of the project report, choice
of technology, selection of the plant and machinery, detailed engineering and so on. While the
amount payable for obtaining the technical know-how and engineering services for setting up the
project is a component of the project cost, the royalty payable annually, which is typically a
percentage of sales, is an operating expense taken into account in the preparation of the projected
profitability statements.

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8. Expenses on Foreign Technicians and Training of Indian Technicians Abroad
Services of foreign technicians may be required in India for setting up the project and
supervising the trial runs. Expenses on their travel, boarding, and lodging along with their salaries
and allowances must be shown here. Likewise, expenses on Indian technicians who require
training abroad must also be included here.
9. Miscellaneous Fixed Assets
Fixed assets and machinery which are not part of the direct manufacturing process may be
referred to as miscellaneous fixed assets. They include items like furniture, office machinery and
equipment, tools, vehicles, railway siding, diesel generating sets, transformers, boilers, piping
systems, laboratory equipment, workshop equipment, effluent treatment plants, firefighting
equipment, and so on. Expenses incurred for the procurement or use of patents, licenses,
trademarks, copyrights, etc. and deposits made with the electricity board may also be included
here.
10. Preliminary and Capital Issue Expenses
Expenses incurred for identifying the project, conducting the market survey, preparing the
feasibility report, drafting the memorandum and articles of association, and incorporating the
company are, referred to as preliminary expenses. Expenses borne in connection with the raising
of capital from the public are referred to as capital issue expenses. The major components of capital
issue expenses are: underwriting commission, brokerage, fees to managers and registrars, printing
and postage expenses, advertising and publicity expenses, listing fees, and stamp duty.
11. Pre-operative Expenses
Expenses of the following types incurred till the commencement of commercial production
are referred to as pre-operative expenses:
(i) Establishment expenses,
(ii) Rent, rates, and taxes,
(iii) Travelling expenses,
(iv) Interest and commitment charges on-borrowings,
(v) Insurance charges,
(vi) Mortgage expenses,
(vii) Interest on deferred payments,
(viii) Start-up expenses and

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 (ix) Miscellaneous expenses.

12. Provision for Contingencies

A provision for contingencies is made to provide for certain unforeseen expenses and price
increases over and above the normal inflation rate which is already incorporated in the cost
estimates. To estimate the provision for contingencies the following procedure may be followed:
(i) Divide the project cost items into two categories, viz., ‘firm’ cost items and ‘non-firm’
cost items (firm cost items are those which have already been acquired or for which
definite arrangements have been made).
(ii) Set the provision for contingencies at 5 to 10 percent of the estimated cost of non-firm
cost items. Alternatively, make a provision of 10 percent for all items (including the
margin money for working capital) if the implementation period is one year or less. For
every additional one year, make an additional provision of 5 percent.

13. Margin Money for Working Capital

The principal support for working capital is provided by commercial banks and trade
creditors. However, a certain part of the working capital requirement has to come from long-term
sources of finance. Referred to as the ‘margin money for working capital’, this is an important
element of the project cost. The margin money for working capital is sometimes utilised for
meeting over runs in capital cost. This leads to a working capital problem (and sometimes a crisis)
when the project is commissioned. To mitigate this problem, financial institutions stipulate that a
portion of the loan amount, equal to the margin money for working capital, be blocked initially so
that it can be released when the project is completed.
14. Initial Cash Losses
Most of the projects incur cash losses in the initial years. Yet, promoters typically do not
disclose the initial cash losses because they want the project to appear attractive to the financial
institutions and the investing public. Failure to make a provision for such cash losses in the project
cost generally affects the liquidity position and impairs the operations. Hence prudence calls for
making a provision, overt or covert, for the estimated initial cash losses.

Sources of Finance Margin Money

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 The major classification of long-term sources is debt financing (outsider’s liability) and
equity financing (insider’s liability).

I. Debt Financing

Debt funds are the outsider’s liability. The funding agencies evaluate the project and
provide finance for the same with predetermined terms of returns and repayments. The repayment
schedule is predetermined and so is the interest rate. The term, or time limit to pay a debt, is
generally commensurate with the value of an item or investment. Business and governmental
bodies carry longterm debt in the form of loans or bonds. Loans are taken from banks or other
financial institutions and are paid back with an agreed interest rate. Bonds or debentures are similar
to loans, but are usually purchased by individuals or other businesses.

Types of Debts

There are two broad classifications of debts: loans and debentures

Loans

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 Loans are the most common source of financing. There are several development
banks/institutions and commercial banks providing finance with a predefined rate of interest. The
repayment schedule is also predefined. Repayments are generally made in installments
(quarterly/semi annually/annually) whereas interest payment is generally on quarterly basis in
India. There are various banks/institutes providing loans. Some of them are:

• Central Financial Institutions/development banks: Financial intuitions like IFCI (Industrial

Financial Corporations of India), IRBI (Industrial Reconstruction Bank of India), and
development banks like IDBI (Industrial Development Bank of India), ICICI Bank, SIDBI,
GIC, EXIM, etc.
• State Financial Corporation (SFC): All major states have their own SFC for funding
medium sized projects. They all are refinanced by IDBI.
• State Industrial Development Corporations (SIDCO): The role of SIDCO is not restricted
to financing but they are also responsible for zones for industrial developments and
infrastructural facility.
• Commercial banks: All commercial banks finance long-term debt at a predefined rate of
interest, generally with collateral security. Both nationalized and private commercial banks
are playing a major role in financing agro industries and service projects.
• Private financing: Private companies and NBFC are also providing long term loans for
projects.
• International financial institutions: These institutions provide funding to the projects of
great magnitude. World Bank, International Finance Corporation, Asian Development
Bank, Overseas Economic Co – operation Fund, etc.
Debentures

Debentures are loans that are usually secured and are said to have either fixed or floating
charges with them. They are different from loans as loan is provided by a bank or an institution
whereas debenture is funded by public or group of people. A secured debenture is one that is
specifically tied to the financing of a particular asset such as a building or a machine. Then, just
like a mortgage for a private house, the debenture holder has a legal interest in that asset and the
company cannot dispose of it unless the debenture holder agrees. If the debenture is for land and/or
buildings, it can be called a mortgage debenture. Debenture holders have the right to receive their

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interest payments before any dividend is payable to shareholders and, most importantly, even if a
company makes a loss, it still has to pay its interest charges. If the business fails, the debenture
holders will be preferential creditors and will be entitled to the repayment of all of their money
before the shareholders receive anything. This provides safety to the holders of debentures.

II. Equity Financing

Although owners of equity instruments are the owners of a company, it is actually equity
shareholders who are the real owners of the company. There are various sources of equity
financing.
• Preference shares
• Equity shares
• Returned earnings

Preferential Shares
Preference shares offer their owners preferences over ordinary shareholders. There are two
major differences between ordinary and preference shares:
1. Preference shareholders are often entitled to a fixed dividend even when ordinary
shareholders are not.
2. Preference shareholders cannot normally vote at general meetings.
Equity Shares
Equity shareholders are the true owners of the company. They have the voting rights and
right on all the remainder profit after paying interest to debt and preferential dividends. Who owns
Reliance Industries? Mukesh Ambani? No, he is just holding majority stake of the company, and
so he is controlling the company. All shareholders of Reliance industries are the owners of the
company. Returns to shareholders are in the form of dividends, right shares or bonus shares.
Generally, the return expected by shareholders is in the form of increased market prices. Future
aspects, profits, reserves and all the aspects of the company are depicted by its share prices. The
value of the company is determined by market price/share x No. of shares issued.

Retained Earnings

Retained earning is the cheapest of equity source of capital. Companies do not declare
dividends equal to their earnings; they retain some portions of their earnings for various reasons.

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One of the major reasons is future prospects. Such reserves are used as source of funding of a new
project (generally in the case of brown field projects).

Short-Term Sources for Working Capital

The various short term sources of funds are

• Cash credit limit/overdraft by banks: This is a form of loan provided by a bank.

This is a cheaper means of fund as interest is payable on the amount which is withdrawn
on a particular date. Banks offer a drawing limit to business for meeting its requirement
of funds for working capital needs for raw material storage, work in progress, finished
goods stock and debtors.

• Commercial papers: Commercial paper is an unsecured, short-term debt instrument

issued by a company, typically for the financing of accounts receivable, inventories and
meeting short-term liabilities.

• Factoring: Factoring is a financial option used for the management of receivables.

• Hundies: It is very ancient source of financing short-term funds. A firm needing short-
term funds for meeting its working capital needs raise the funds privately at a predefined
rate of interest through money market. This is generally dependent on the goodwill
earned by the borrower.

• Trade credit: Firm do take advantage of their good will during purchasing goods on
credit thus reducing working capital requirement. Many firms also take deposits from
their distributors which in turn provide them funds for working capital. Some firms also
sell their product after receiving advances, which also provide funds for their working
capital requirement.

Newer Sources of Finance

1. International financing: The International Finance Corporation (IFC), the

Multilateral Investment Guarantee Agency (MIGA), and International Project Financing

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 Agency (IPFA) give loans to promote private sector, corporate investment in developing
countries, under the theory that such investment will provide economic growth. Other
major sources of international financing include Euro Currency loans, Euro Bonds,
Global Depositary Receipt and American Depository Receipts.

2. Leasing: Lease is an agreement between two parties, the lessee and the lessor. The
lessor purchases capital goods for the use of the lessee and the lessee uses it by payment
of predefined rentals. The lessee continues to be the owner of the asset. Leasing is
generally used for financing capital goods.

3. Hire purchase: It is a form of installment credit. Hire purchase is similar to leasing

with the exception that ownership of the goods passes to the hire purchase customer as
soon as the final installment is paid, whereas a lessee never becomes the owner of the
goods.

4. Venture Capital Financing: Venture capital is the capital provided by outside

inventors for financing of new, innovative or struggling business. Venture capital
investments generally are high risk investments, but offer the chance for above average
returns. A venture capitalist (also called angel investor) is a person who makes such
investments. A venture capital funds is a pooled investment vehicle (often a partnership)
that primarily invests the financial capital of third-party investors in enterprises that are
too risky for the standard capital markets or bank loans. A venture capitalist is an expert
not only in acquiring capital, but can also provide support and direction to early startups.

Promoters Contribution

An entrepreneur who promotes the project will also participate in the scheme of finance of
the project. The extent of promoter’s participation is considered as sign of interest the promoters
show in the project. When the bank/financial institution is asked to participate in the scheme of
finance, they would ask the promoters to bring a certain portion, normally between 25 to 50% of
the project cost into the equity share capital of the company.

A part of the contribution can be arranged by the promoters from outside sources like
arranging investment in capital from friends and relatives. For eligibility of financing, the financial

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institutions will stipulate minimum promoters’ contribution which is to be arranged by the
promoter. The financial institutions always press for the slightly higher participation in the project.

This is to ensure a long and continued involvement of the promoter in the project.
Promoters’ contribution indicates the extent of their involvement in the project in terms of their
own financial stake. The promoters contribution will be provided in the form of subscribing to
equity and preference shares issued by the company, unsecured loans, seed capital assistance,
venture capital assistance, internal accrual of funds.

Project Appraisal Process by Banks and Financial Institutions

Banks and Financial institutions such as IDBI Bank, ICICI Bank, and the Industrial Finance
Corporation of India (IFCI), and the State Industrial Development Corporations (SIDCs) and State
Financial Corporations (SFCs) of different States, as also Investment Finance Institutions such as
the Life Insurance Corporation (LIC), the General Insurance Corporation (GIC) and the Unit Trust
of India (UTI) have for long been actively involved in promoting industrial projects and
participating in their operational phases and have emerged as major stockholders in most
enterprises. They participate in and underwrite equity and debentures and provide medium and
long-term loans, often accounting for the major part of funds employed in enterprises. Before they
commit their funds, they have to necessarily satisfy themselves about the feasibility of the projects
to be assisted.

The Appraisal Process

Small projects get assistance from a single institution, and in the case of larger projects, the
institutions extend assistance jointly through syndication.

1. Single Institution Assistance – The Process The evaluation proceeds in the following
sequence, where a single financial institution is involved:

(a) Application is received from the promoter.

(b) The institution deputes a financial expert and technical expert to carry out the
project appraisal;

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 (c) After a preliminary review, the team submits its report to the management,
recommending acceptance or rejection. If accepted in principle, further details for
closer scrutiny are obtained from the promoter.

(d) The crucial aspects of the project proposal are subjected to in-depth study.
Elaborate discussions are held with the promoter, and the underlying assumptions get
certified and substantiated. Comparisons with similar projects, assessment of the
technical suitability of the basic engineering package, verification of the collaboration
agreements, scrutiny of price bids of contractors and suppliers’ quotations, verification
of market studies, inspection of the site, and seeking expert opinions where required
are all essential steps in this in-depth analysis.

(e) Detailed evaluation of the technical, commercial, financial, economic and

management aspects are taken up for ascertaining the project’s viability, and its
acceptability for project financing.

(f) The senior executives of the institution have a close look at the proposal, with
reference to available reports and comments.

(g) Further discussions are held with the promoter and necessary modifications are
agreed upon.

(h) The final appraisal memorandum is prepared and submitted to the managing
director.

(i) The final appraisal memorandum goes to the board of directors for approval.

(j) The promoter is informed of board’s approval.

2. Loan Syndication

Syndicate as term in general sense has originated in the U.S. Loan Syndication refers to a
lending process wherein a borrower approaches a bank for a loan amount that is comparatively
heavy and also involves international transactions and different currencies. Here, as and when a
bank is approached by a client for availing a loan, the said bank fixes up the interests and other
borrowing terms and conditions of the loan with the client and itself approaches other banks for

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selling of this loan. The other banks, if agree, “Purchase” a part of the loan on the same or different
terms and conditions. In a Loan Syndication process, the client deals with one Bank only. The
bank approached by the borrower to arrange credit is referred to as Managing Bank that is
responsible for negotiating conditions and arranging the loan amount. Here it is important to note
that the Managing Bank need not be the “Majority lender” or “Lead bank” but only plays the role
of manager in arranging the loan amount in association with other banks. Depending on the terms
and conditions of the agreement any bank can play the role of Managing Bank. The lead bank acts
as recruiting bank of other sufficient banks in the process of producing of loan, negotiating the
terms, negotiating details of the agreement and preparing documentation. The bank that is
awarded/ given the mandate by prospective borrower and is responsible for placing and managing
the loan process, its terms and conditions and finalizing the same is known as Lead Manager, Lead
Bank, Syndicate Bank. They are entitled to arrangement fees and undergo a reputation risk during
this process.

A borrower takes resort of Loan Syndication for Working Capital credit, Export Finance,
Capital goods financing, Mergers and Acquisitions, Project Finance, Standby facility, Trade
finance, guarantees etc.

Advantages

1. Allows the borrower to access from diverse group of financial institutions.

2. Saves funds. The interest rates, other terms and conditions are agreed upon by one bank
that has to approach the pool of banks for the loan; this process saves money and time on
part of the borrower.

3. Raise substantial financing facilities on pre-agreed terms which would exceed the
capacity of any single bank

Disadvantages

1. Each bank has to come to an understanding about business and how its financial
activities take place. 2. Comfort level must be arrived at, that requires time and effort.

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 3. Negotiating the documents and other terms with one bank takes days. Here the
borrower has to negotiate with numerous banks and is time consuming.

Consortium

There arise cases where a borrower approaches a bank for huge loans; this high amount
means high risk to a single lender. In such cases banks resort to a lending mechanism known as
Consortium to reduce the risk involved in the Loan Process. A consortium is successful where it
is not possible for a single bank to finance the loan amount to the borrower; it has nothing to do
with international transactions unlike Loan Syndication, simply the loan amount is too large or
risky for a single lender to provide. Consortium financing occurs for transactions that might not
take place with a single lender. Here when a borrower approaches a bank for loan, several banks
club together to supervise the said loan amount. A common appraisal, documentation, joint
supervision and followup play the key role.

hese banks have a common agreement between them. Sometimes the participating banks
form a new consortium bank to look after the process of funding of loan, leveraging assets from
each institution and ultimately disbanding after completion of the project. The lender who has
taken the highest risk (by giving the highest amount of loan) acts act as a leader and administers
all the transactions, agreements etc. between the consortium and the borrower. The consortium
agreement is a crucial document and not easy to draft. It must be clear on the rights and obligations
of the parties, which need to be focused firmly on the purpose of the consortium.

Advantages of consortium

1. No capital is required to create a consortium.

2. Ease of formation, no formal procedures need to be followed.

3. It is easy to terminate because it can be set to expiry on a particular date and

happening of an event without any formal requirements.

4. It is easy to terminate, can be set to expiry on a given date or on the occurrence of

certain events without the formal requirements needed in the case of dissolution of a
corporation.

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 5. The individual members are subject to tax and not the consortium.

Disadvantages of consortium

1. A consortium member can’t restrict or limit its liability. Members may even
become liable to third parties for the non-performance of other members of the
consortium or the debts of such members incurred in undertaking the common
project.

2. Third parties often find it difficult to enter into contract with a non-legal entity
like a consortium. Because it is a non-legal entity funding is also normally only
available to the individual members and not the consortium itself. So it becomes
difficult to maintain External relationship and funding.

3. The lack of a permanent structure makes it difficult for a consortium to establish

long-term business relationships with third parties.

Role of Lead Bank in Consortium

1. Conducting consortium meetings.

2. Obtaining of necessary documents, clarification etc. from the borrower.

3. Making arrangements for joint appraisal of loan proposal by all member Banks.
Preparation of joint appraisal report and sending the same to all member Banks and
finalization of decision after discussions. 4. Fixing and Deciding of Loan limit.

5. Custody, Verification of documents, securities etc., on behalf of itself and

consortium Banks.

6. To maintain mutual interest between consortium Banks and term loan lending
institutions, making correspondence with National/State level Financial Institutions.

7. Obtaining stock statement and other legal obligations every month and ensuring
maintenance of adequate stock for the loan.

8. Passing on recoveries on pro rata basis to the entire consortium Banks.

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 9. Ensuring of all transactions by borrower through Cash Credit A/c maintained with
the Lead Bank and that the utilization of the loan advanced is only for production
activities.

Role of Consortium Banks

1. Participating in consortium meetings and using their expertise in the general

interest of consortium. 2. Authorizing the Lead Bank to take decision in the interest
of consortium Banks.

3. The Consortium Banks are not supposed to demand the loss incurred and change
their lending share without obtaining prior approval from the consortium members.

4. Act in accordance with the terms and conditions agreed upon between the Lead
Bank and other banks. Faced with higher defaults, banks have become more cautious
on non-investment-grade corporate loans. They have started pushing more corporate
loan accounts to enter into consortium lending arrangements, to improve the access
to information and avoid surprises.

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