5
Financing Projects, Their Risks and Risk Modelling
5.1 INTRODUCTION
It is important to understand the difference between corporate and project finance. Corporate finance is traditional finance where payment of loans comes from the organisation, backed by the organisation’s entire balance sheet, not from the revenues of projects. Lenders look at the overall financial strength or balance sheet of an organisation as a prerequisite for lending for a project (Merna and Njiru 2002). In project finance, projects are undertaken by a special project vehicle (SPV), owing to the fact that the project is an off-balance-sheet transaction. Lenders have no recourse to the main organisation’s assets.
In this chapter the main sources of finance are discussed. It then briefly describes the major stages of risk faced during the management process, namely identification, analysis and response. The risks affecting financial options are outlined along with how these risks can be managed. The chapter also outlines the uses and benefits of risk management software and modelling.
5.2 CORPORATE FINANCE
Corporate finance is the specific area dealing with the financial decisions corporations make and the tools and techniques used to make the decisions. The discipline as a whole may be divided between long-term capital investment decisions and short-term working capital management.
Figure 5.1 summarises the corporate finance process and illustrates the three categories of corporate financial decision making. These categories include:
• Objectives – investment decisions. Management must allocate limited resources between competing opportunities. Corporate-level management face these decisions on a regular basis and develop expertise and specific industry knowledge which aids the decision-making process.
• Financial decisions. Any corporate investment must be financed appropriately. The financing mix can impact the valuation of an organisation (and hence the level of risk an organisation faces will be affected). Management must therefore identify the ‘optimal mix’ of financing – the capital structure that results in maximum value (Damodran 1997).
• Financial techniques available – dividend decisions. Management must decide whether to invest in additional projects, reinvest in existing operations, or return free cash as dividends to shareholders. The dividend is calculated mainly on the basis of the organisation’s unappropriated profit and its business prospects for the coming year. If there are no NPV positive opportunities then management must return excess cash to investors. Techniques which can be applied to this decision-making process include (Damodran 1997):
• present value
• financial statement analyses
• risk and return ○ option pricing.
Figure 5.1 The hierarchy of corporate finance objectives
Most corporations are financed through a mixture of debt and equity. The gearing of a corporation is determined by the ratio of debt to equity. A highly geared corporation will have high debt borrowing and a low geared corporation a high equity stake. Many corporations seek to identify the weighted cost of capital. Table 5.1 shows an example of the weighted cost of capital.
Table 5.1 The weighted cost of capital
The risks to corporations regarding the debt-equity ratio are twofold.
1. A high debt-equity ratio requires debt to be serviced as per the terms of the loan often at the expense of shareholders through low dividend payments.
2. A high proportion of equity can result in the risk of the corporation losing control of the entity to shareholders.
5.3 PROJECT FINANCE
The concept of project finance is widely used in business and finance in developed countries, although there is currently no precise legal definition of ‘project finance’.
The term project finance is used to refer to a wide range of financing structures. However, these structures have one feature in common – the financing is not primarily dependent on the credit support of the sponsors or the value of the physical assets involved. In project financing, those providing the senior debt place a substantial degree of reliance on the performance of the project itself (Tinsley 2000).
Merna and Owen (1998) have described the concept of project finance in the following way:
Each project is supported by its own financial package and secured solely on that project or facility. Projects are viewed as being their own discreet entities and legally separate from their founding sponsors. As each project exists in its own right, SPV’s are formulated. Banks lend to SPV’s on a non or limited recourse basis, which means that loans are fully dependent on the revenue streams generated by the SPV, and that the assets of the SPV are used as collateral. Hence, although there may be a number of sponsors forming the SPV, the lenders have no claim to any of the assets other than the project itself.
Project financing refers to the long-term financing of infrastructure, industrial projects and public services based upon non-recourse or limited recourse financial structures where project debt, mezzanine finance (usually in the form of bonds) and equity are used to finance the project and paid back from the cash generated by the project (International Project Finance Association in 2003). Private sector organisations use project finance as a means of funding major concession projects off balance sheet. The essence of project finance is to create a robust financing structure for the private enterprises in which risks are contained within the project itself, leaving no recourse to the project’s sponsors.
Esty (2004) concurs with the definitions of project finance given above, but states that the following should not be considered as project finance: secured debt, vendor-financed debt, subsidiary debt, lease, joint ventures or asset-backed securities, since all these infer recourse to assets.
5.3.1 Basic Features of Project Finance
Within project finance there are features which form an integral part of the finance tool (Nevitt 1983). Below is a brief description of each of these features.
5.3.2 Special Project Vehicle (SPV)
An SPV is a separate company from the promoter’s organisation and operates under a concession, normally granted by government. Usually, the seed equity capital for the SPV is provided by the sponsors of the project company (Spackman 2002). An SPV is usually highly geared, through a high debt to equity ratio.
5.3.3 Non-recourse or Limited Recourse Funding
In non-recourse funding the lenders to the project have no recourse to the general funds or assets of the sponsors of the project. However, in limited recourse, access to the sponsor’s general assets and funds is provided if the sponsors provide a guarantee of repayment for certain identified risks.
Advantages are as follows. Lenders will have more confidence because the project is not burdened with losses or liabilities from activities unrelated to the project. Non-recourse lending also helps to protect the security interests of the lenders in the project company with a right to replace the project management team in the event of poor performance of the project or even to foreclose and sell the project (step-in clauses) to recover their interests in the project to the maximum possible extent.
A disadvantage could be that investors are left with a partially completed facility that has little or no residual value. Lenders therefore have to act very cautiously and completely satisfy themselves that the project facility will be able fully to meet its debt, bonds and equity liabilities, and on top of that earn a reasonable margin of profit for the sponsors to retain their interest (Merna and Dubey 1998).
5.3.4 Off-balance-sheet Transaction
The non-recourse nature of project finance provides a unique tool to project sponsors to fund the project outside their balance sheet. This structure enables funding of a variety of projects which might not otherwise have been funded, particularly when the sponsors:
• either are unwilling to expose their general assets to liabilities to be incurred in connection with the project (or are seeking to limit their exposure in this regard)
• or do not enjoy sufficient financial standing to borrow funds on the basis of their general assets (Benoit 1996, Heald 2003).
5.3.5 Sound Income Stream of the Project as the Predominant Basis for Financing
The future income stream of the project is the most critical element in any project financing. The entire financing of the project is dependent on an assured income stream from the project since lenders and investors have recourse to no funds other than the income streams generated by the project, once it is completed, and assets of the project that may or may not have any residual value (Spackman 2002). The project sponsors, therefore, have to demonstrate evidence of future income through various means such as a power sales contract for a power plant, a concession agreement for a toll road project allowing the collection of tolls, or tenant leases for a commercial real estate project (Tinsley 2000). Modelling projects through computer software can be an effective way of securing finance. Expected costs and revenues can be input into a simulation model and decisions can be made as to whether the project should be sanctioned.
5.3.6 Projects and Their Cash Flows
Broadly speaking, a project may be said to pass through three major phases:
1. project appraisal
2. project implementation
3. project operation.
Cash flow is defined by the sum of cash inflows and cash outflows through the project stages in a particular time period. The cash flow of a project is the only source of income for the promoter. After servicing the debt, paying the dividends on equity, paying the coupon rate on bonds, spending for general operation and maintenance, and tax to the government, the promoter is left with either a surplus or a deficit. The amount of surplus or deficit depends on the terms of repayment, the revenue generation capacity of the SPV and the risks involved in the project. A project can still be considered a risk until it crosses the break-even point. During the appraisal phase, the projected cash flows of a project would be the basis on which various contractual agreements with the parties involved are shaped and a decision whether to sanction the project or not is made.
Cumulative cash flows, also known as net cash flows, are defined as the sum of cash flows in each fiscal year of the project. The cumulative flow for a particular year in the life cycle of the project is calculated by adding the net cash inflows to the net cash outflows (Turner 1994). Cumulative cash flows can be used to determine surpluses or deficits within each time period.
A typical cumulative cash flow curve for a project is illustrated in Figure 5.2.
The precise shape of the cumulative cash flow curve for a particular project depends on variables such as:
• the time taken in setting up the project’s objective
• obtaining statutory approvals
• design finalisation
• finalisation of the contracts
• finalisation of the financing arrangement
• the rate and amount of construction
• operation speed.
Figure 5.2 Typical cumulative cash flow stages of a project
Negative cash flow, until a project breaks even, clearly indicates that a typical project needs financing from outside until it breaks even. The shape of the curve also reveals that in the initial phase of the project relatively less financing is required. As the project moves on to the implementation phase there is a steady increase in the finance requirement, which peaks at the completion stage. This point is defined as the cash lock-up (CLU) in the project. The rate of spending is also depicted by the steepness of the curve. The rate of spending is often termed the ‘cash burn’, which is the rate at which cash is spent over a specified period of time. The steeper the curve, the greater the need for finance to be available. Once the project is commissioned and starts to yield revenues the requirement of financing from outside the project becomes less. Finally, the project starts to generate sufficient resources for the operation and maintenance and also a surplus of cash. However, even after the break-even point, the project may require financing for short periods, to meet the mismatch between receipts and payments (Merna and Njiru 2002).
In project financing, it is this future cash flow forecast that becomes the basis for raising resources for investing in the project. It is the job of the finance manager of the project to package this cash flow in such a way that it meets the needs of the project and at the same time is attractive to potential agencies and individuals willing to provide resources to the project for investment. In order to achieve this objective effectively, a thorough knowledge of the financial instruments and the financial markets in which they are traded is essential (Khu 2002).
Cash flows and their relationship to portfolios are discussed in Chapter 6.
5.4 FINANCIAL INSTRUMENTS
Organisations procuring projects need to raise cash to finance their investment activities. In most cases capital is raised through issuing or selling securities. These securities, known as financial instruments, are in the form of a claim on the future cash flow of the project. At the same time, these instruments have a contingent claim on the assets of the project, which acts as a security in the event of future cash flows not materialising as expected. The nature and seniority of the claim on the cash flow and assets of the project vary with the financial instrument used.
The authors describe financial instruments as the tools used by an organisation/promoter to raise finance for a project.
Traditionally, financial instruments were in the form of either debt or equity. However, developments in the financial markets and financial innovations have led to the development of various other kinds of financial instruments which share the characteristics of both debt and equity. These instruments are normally described as mezzanine finance instruments, particularly bonds. Debt is senior to all other claims on the project cash flow and assets (Merna and Njiru 2002).
Ordinary equity refers to the ownership interest of common stockholders in the project. On the balance sheet, equity equals total assets less all liabilities. It has the lowest rank and therefore the last claim on the assets and cash flow of the project. Equity is best described as ‘risk finance’.
Mezzanine finance occupies an intermediate position between the senior debt and the common equity. Mezzanine finance typically takes the form of subordinated debt, junior subordinated debt and preferred stock, or some combination of each.
Besides debt, equity and mezzanine finance a project may also utilise certain other types of instruments such as leasing, venture capital and aid.
5.5 DEBT
Debt instruments refer to the raising of term loans from banks or other financial institutions which include commercial, merchant and investment banks, development agencies, pension funds and insurance companies, debentures and export credits.
5.5.1 Term Loans
Term loans are negotiated between the borrower and financial institutions. For large projects a group of banks and financial institutions pool their resources to provide the loans to the project. This is known as syndicated lending. Banks and financial institutions set their own internal exposure limits to particular types of project. This helps in spreading the risk. Generally an investment bank or a merchant bank acts as the agent or lead bank to manage the debt issue. Many banks specialise in lending to certain types of infrastructure projects of which they have both technical and financial experience. For example, development banks in transitional and developing countries.
The terms and conditions of loans vary between different lenders and borrowers. There can be a fixed interest rate or floating interest rate. Repayment of the loan could be between 7 and 10 years for an oil sector project to 16 and 18 years for a power project (Merna and Owen 1998). One reason for variance is the ‘gestation lag’ of the project. The type of loan is determined by the project’s characteristics and availability of the instruments.
According to Merna and Smith (1996) the cost of raising debt capital includes certain fees besides the interest. These are:
• Management fee. A percentage of the loan facility for managing the debt issue, normally to be paid up front.
• Commitment fee. Calculated on the undrawn portion of the loan to be paid when the loan is fully drawn.
• Agency fee. Normally an annual fee to be paid to the lead bank for acting as the agent to the issues after the loan has been raised.
• Underwriting fee. Paid up front as a percentage of the loan facility to the bank or financial institution which guarantees to contribute to the loan issue if it is not fully subscribed.
• Success fee. Paid up front as a percentage of the total loan once all loans have been secured.
• Guarantee fee. Paid annually on the outstanding loan amount if it is guaranteed against default.
All, none or some of these may be present in a specific loan proposal. In certain cases the lenders submerge all the fees in the interest rate they offer. A careful analysis of the cost of loans offered from different sources is therefore required. Still the overall cost of raising a term loan is less compared with any other mode of large-scale financing because the project has to negotiate and deal with only a small number of lenders of money through a lead manager of the issue. Also, in the event of default it is easier to renegotiate a term loan compared with any other instrument of financing (Tinsley 2000).
5.5.2 Standby Loans
An organisation/promoter may arrange standby loans with the lenders. Standby loans are more expensive than term loans, since they are used to meet draw-down in excess of term loans, which are often due to lower than expected revenues in the early phase of the operation (Merna and Njiru 2002).
5.5.3 Senior and Subordinate Debt
Senior debt ranks the highest among the financial instruments in terms of claims on the assets of a corporation/project. This means that in the event of default, the lenders of senior debt have the right to claim on the assets of the projects first (Khu 2002). Lenders take into account the debt service coverage ratio (DSCR), defined by Merna and Smith (1996) as the annual cash flow available for debt service divided by the loan balance outstanding. In the UK lenders seek a typical DSCR of 1.2 based on the economic parameters of the worst case scenario. In developing markets the DSCR can be as high as 2.8, basically this is a contingency required by lenders (Lamb and Merna 2004b). Each industry sector tends to have a target DSCR ratio based on the characteristics of the industry. Tinsley (2000) claims that the risk adjustment is made in project financing and the project financier has to adjust a specific project financing structure to generate its corresponding target DSCR. Typically, power sector projects have a lower DSCR than infrastructure projects whereas infrastructure projects tend to be lower than mining, oil and gas and telecoms projects.
Subordinate debt is subordinate to senior debt and generally has only second claim to the collateral of the project company. This means that in the event of default by the promoter, all senior debt claims must be met before any claim can be made by subordinate debt lenders. As it is second to senior debt in terms of claims on assets, lenders seek higher returns on subordinate debt. The interest rate on it is usually higher than the interest rate on senior debt (Khu 2002). For example, the interest rate on senior debt may be London interbank offered rate (LIBOR) plus 200 basis points, but the interest rate on subordinate debt could be LIBOR plus 400 basis points. Subordinate debt is often used for refinancing needs or for the restructuring of the finance package of a project.
5.6 MEZZANINE FINANCE INSTRUMENTS
There are many financial instruments in this category. They are senior with respect to an equity issue and lower than debt. Some of them are close to a debt issue and some of them share features of an equity issue.
Higgins (1995) defines bonds as a fixed income security. The holder receives a specified annual interest income and a specified amount at maturity (unless the organisation goes bankrupt). The difference between bonds and other forms of indebtedness such as term loans and secured debenture is that bonds are a subordinate form of debt compared with term loans and secured debentures. Similar to debentures, these are issued by the borrowing entity in small increments, usually $1000 per bond in the USA. After issue, the bond can be traded by investors on organised security exchanges.
Khu (2002) identifies the variables which characterise a bond, namely:
• par value
• coupon rate
• maturity date
• bond yield
• yield to maturity.
In a sinking fund arrangement, bonds can be either repaid entirely at maturity or repaid before maturity. The repayment takes place through a sinking fund. A sinking fund is an account maintained by the bond trustee for the repayment of bonds. Typically the borrower makes an annual payment to the trustee. Depending on the indenture agreement, the trustee can either purchase bonds from the market or select bonds randomly using a lottery and purchase them, generally at face value. A sinking fund has two opposing effects on the bondholders: it acts like an early warning system, for the lenders, when the borrower is in financial difficulties and unable to meet the sinking fund requirements; and it is beneficial to the borrowers both when the price of the bond is high as well as when it is low. In the event of lower market bond price the borrower buys back the bonds at the lower market price and in the event of higher market bond price the borrower still buys the bonds at the lower face value (Tinsley 2000).
5.6.1 Bond Ratings
The success of a bond issue, inter alia, depends upon its credit quality. There are many companies which analyse the investment qualities of publicly traded bonds. The findings are published in the form of bond ratings. The ratings are determined by using various financial parameters of the borrowing agency, general market conditions in which the borrower operates, the political situation of the country in which the project is located, and other sources of finance which have been tied up by the project. The ratings are based, in varying degree, on the following considerations:
• the likelihood of default by the bond issuer on its timely payment of interest and repayment of principal
• the nature of the bond
• provisions of the obligations.
The ratings are normally depicted in letters such as A, B or C or a combination of letters and numbers such as in certain financial markets; public issue of bonds is not permitted if the bonds have not been rated, such as the US bond market. Rating is also important because bonds with lower ratings tend to have higher interest costs. The rating agencies keep reviewing the financial performance of the borrower, the general market situation and the political situation in the country of the borrower. Depending upon the emerging situations the ratings are revised upwards or downwards.
An organisation’s ability to honour interest payments and principal payment on schedule is important to bondholders. Some organisations are financially stronger than others and this affects their ability to honour the debt. An organisation’s ability to pay off its debt is rated. Bond ratings are a reflection of the creditworthiness of an organisation and are based on:
• the likelihood an organisation will default on its interest repayment
• the likelihood an organisation will default on its principal repayment
• the creditors’ protection in the event of a default.
The two leading bond-rating organisations are Standard and Poor’s (S&P) and Moody’s. Table 5.2 explains the ratings and the definitions of the types of bonds available.
Table 5.2 Bond ratings (Adapted from Khu 2002, Merna 2002)
| Bond ratings | ||
|---|---|---|
| S&P | Moody’s | Comments |
| High-grade bonds | ||
| AAA | Aaa | Capacity to pay interest and principal is very strong |
| AA | Aa | |
| Medium-grade bonds | ||
| A | A | Strong capacity to pay interest and repay principal, although it is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions. Both high-grade and medium-grade bonds are investment-quality bonds |
| BBB | B | |
| Low-grade bonds | ||
| BB | Ba | Adequate capacity to pay interest and principal, although adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and principal. These are regarded as mainly speculative bonds, with CC and Ca being the bonds with the highest degree of speculation |
| B | B | |
| CCC | Caa | |
| CC | Ca | |
| Very low-grade bonds | ||
| C | C | This rating is reserved for income bonds on which no interest is being paid |
| D | D | This rating is in default, and payment of interest and/or repayment of principal is in arrears |
5.6.2 Types of Bonds
5.6.2.1 Plain Vanilla Bonds
A plain vanilla or fixed rate bond is a bond for which the coupon rate is fixed at the time of issuing the bond. The disadvantage of a fixed rate bond is that the bondholder will be at a loss if inflation rises and interest rates move up during the maturity period. On the other hand, the bondholder will be in profit if interest rates fall, as the bondholder will be getting coupons at the previously agreed rate.
5.6.2.2 Floating Rate Bonds
These are bonds for which the coupon rate is adjusted periodically according to a predetermined formula. The coupon rate is tied to some short-term interest rate such as the six-month LIBOR. In this case, when the inflation and interest rates fluctuate during the maturity period, the coupon rate will be adjusted accordingly following the predetermined formula. Generally floating rate bonds sell at or near par.
5.6.2.3 Zero Coupon Bonds
These are also known as a deep discount or pure discount bonds, or original issue discount bonds or zeros. Zero coupon bonds do not pay interest through the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their par value, which is the amount the bond will be worth when it matures or comes due. When a zero coupon bond matures, the investor will receive one lump sum equal to the initial investment plus the interest that it has accrued. These long-term maturity dates allow an investor to plan for a long-range goal, such as paying for a child’s college education. With the deep discount, an investor can put up a small amount of money that can grow over many years.
5.6.2.4 Junk Bonds
These are also known as high-yield bonds or low-grade bonds and with a rating of BB or Ba or lower generally pay interest above the return of more highly rated bonds. Junk bonds are considered for high-risk projects. For example, a casino, which is considered as a high risk, can be funded through junk bonds (now referred to as high-risk bonds). A casino could also be funded by a revenue bond, whereby investors’ income is directly related to the project’s income/revenue.
5.6.2.5 Municipal Bonds
These are bonds issued by the state or local government unit. The advantage of such bonds is that they are exempt from government tax. They may also be exempt from state and local taxes.
5.6.2.6 Income Bonds
These are bonds similar to revenue bonds, which are linked directly to the borrower’s income. They are similar to conventional bonds except that the coupon payment is made only when the project’s income is sufficient. For example, income bonds used to finance a casino would only pay coupons related to the profits made by the casino which cannot be accurately forecasted at the time of sale.
5.6.2.7 Wrapped and Unwrapped Bonds
Wrapped bonds are guaranteed by a monoline insurer, which makes them very creditworthy. Monoline insurance companies provide guarantees to issuers often in the form of wraps that enhance the credit of the issuer. Issuers will often go to the monoline company either to boost the rating of one of their debt issues or to ensure that a debt issue does not become downgraded. As a result of the guarantee the bonds are rated AAA/Aaa, therefore reducing the cost of borrowing. Unwrapped bonds have no guarantor and the bond is rated on the project itself. The bond pricing will, in turn, be driven by the project’s rating.
The use of bond finance, through private placement, usually depends on the size of the finance required. The Office of Government Commerce (2002) suggests that in the UK bond finance tends to be used in projects requiring in excess of £90 million. For projects between £60 and £70 million, bond finance needs to be assessed in greater detail by monoline insurers to determine whether such finance can be cost effective owing to the costs associated with raising bond finance. Monoline insurers, for example, seek a return of 1% to 2% of the total bond finance raised to cover identified risks.
Table 5.3 illustrates the characteristics of bank and bond financing.
At the time of writing the first edition of this book in 2005 interest rates have tended to increase worldwide. In 2005 interest rates in the UK, USA and EU were 4.75%, 1.25% and 2.0% respectively. At the time of writing this edition of the book the UK base rate is 5.75%, the USA base rate is 4.75% and the EU base rate 3.0%.
These low interest rates have meant that investors have sought debt rather than bonds to finance projects. Many authors also suggest that the sharp decline in the use of bonds since 2002 in the USA is due to the Enron scandal. Debt is the cheapest form of lending and the most flexible, and as such has seen greater demand than bond financing over the last three years.
5.7 EQUITY
5.7.1 Ordinary Equity and Preference Shares
Merna and Owen (1998) define equity capital as pure equity for the provision of risk capital by investors to an investment opportunity and usually results in the issue of shares to those investors.
Rutterford and Carter (1988) define a share as an intangible bundle of rights in an organisation, which both indicates proprietorship and defines the contract between the shareholders. The terms of the contract, that is the particular rights attaching to a class of shares, are contained in the article of association of the company (Merna 2002).
Table 5.3 Characteristics of bond and bank financing (Adapted from Office of Government Commerce 2002)
| Financial characteristic | Bank financing | Bond financing |
| Source of funds | Direct from bank(s) | Bond investors |
| Arrangement of funds | Negotiations between bank and lender | Via bond arranger |
| Certainty of funds | After agreement: certain | Less certainty: Only know if funding is forthcoming when the bond goes on sale |
| Maturity repayments | Up to 30 years | Up to 38 years |
| Flexibility | High: Early payments can be made, and refinancing is possible | Very little. No room for negotiation on interest and capital repayment |
| Receipt of funds | Staged: Works on a draw-down process | Whole: After the bond is sold |
| Assessment of project risk | Banks assess risks | Bond arranger assesses risks |
| Costs | Interest of the funds borrowed, and a commitment fee for funds yet to be drawn down | Interest to the bond investors, a fee to the bond arranger and an insurance fee (optional) |
| Ongoing project scrutiny | Significant. Possible step in clauses | Very little. Bond investors have little influence on the project once it is funded |
| Optimum size | No optimum size | Approximately £100-400 million |
| Opportunities for refinancing | Yes, if project risks become less than those assumed in the initial financing | Unlikely. Bond terms tend to be fixed for the life of the project |
Equity is the residual value of a company’s assets after all outside liabilities (other than to shareholders) have been allowed for. Equity is also known as risk capital, because these funds are usually not secured and have no registered claim on any assets of the business, thus freeing these assets to be used as collateral for the loans (debt financing). Equity, however, shares in the profits of the project and any appreciation in the value of the enterprise, without limitation. Equity holders are paid dividends on the performance of the organisation (dividends are the amount of profits paid to shareholders). No dividends are paid if the business does not make a profit. Dividends to the shareholders can be paid only after debt claims have been met. The return on the equity, therefore, is the first to be affected in case of financial difficulties faced by the project entity. This means that equity investors, in the worst case scenario, may be left with nothing if the project fails and hence they demand greater return on their capital in order to bear a greater risk. This explains the general rule that high-risk projects use more equity while low-risk projects use more debt.
A high proportion of equity means low financial leverage and high proportion of debt equals high leverage. Leverage is measured by the ratio of long-term debt to long-term debt plus equity. Leverage is also called gearing or explained in terms of the debt-equity ratio. High financial leverage means that relatively more debt capital has been used in the project, signifying more debt service and fewer funds being available for distribution as dividend payments to the equity holders. However, once the project breaks even and profits start to accrue, shareholders receive a higher dividend. The seed capital provided by the sponsors of the project, which is normally a very small amount compared with the total finances raised for the project, is also known as founders or deferred shares. These are lower in status compared with ordinary and preference shares in the event of winding up.
In non-recourse financing the debt-equity ratio may be higher if the interest rate is high, provided lenders are satisfied with the risk structure of the project. If, however, a project is considered innovative then more equity will be demanded by lenders and the equity will be drawn down before debt becomes available to the project (Khu 2002).
Ordinary share capital is raised from the general public. Holding these shares entitles dividends, provides the right of one vote per share held, and the right to a pro rata proportion of the project’s winding up. The right to participate in the assets of the project provides the opportunity for highest return on the capital invested (Merna 2002).
Preference shares are the shares that possess priority rights over ordinary shares. These shares give the holder a preferential right over lower ranked ordinary shares in terms of both dividend and return on capital in the event of liquidation. Normally the preference shareholders have the right to a fixed annual dividend, the right to receive repayment of any amount paid up on the preference shares on a winding up, and restricted voting rights. The board of directors of the issuing organisation may decide not to pay the dividend on preferred shares and this decision may have nothing to do with the current income of the issuer organisation (Merna 2002). The dividends payable on the preference shares are either cumulative or non-cumulative. If cumulative dividends are not paid in a particular year they are carried forward. Usually both the cumulative preferred dividend and the current preferred dividend must be paid before ordinary shareholders can receive anything. Unpaid dividends are not treated as debt. The issuer organisation may decide to defer the payment of dividend on preferred shares indefinitely. However, if it does so the ordinary shareholders also do not receive anything. It is argued that preferred shares are in fact debt in disguise. The preferred shareholders receive only a stated dividend, and a stated value in the event of liquidation of the issuing organisation. However, unlike interest on debt, dividend on preferred shares is not deductible before determining the taxable income of the borrower (Merna 2002).
Other forms of financial instruments, such as depository receipts, lease finance and venture capital, are discussed by Merna and Njiru (2002).
5.8 FINANCIAL RISKS
The following financial risks are thought to have the most impact on the financial viability of an organisation/project. These risks all have an effect on the shape of the cumulative cash flow curve. Their effects on projects are identified by Merna and Njiru (2002):
• construction delay
• currency risk
• interest rate risk
• equity risk
• corporate bond risk
• liquidity risk
• counter-party risk
• maintenance risk
• taxation risk
• reinvestment risk
• country risk.
5.8.1 Construction Delay
This is the risk that the construction will not be completed on time or to specification. An uncompleted project is unlikely to generate any revenue and therefore the lenders will not be repaid. Long delays could also increase the cost of the project and therefore reduce its commercial viability, specifically its ability to generate revenues. There are many factors affecting project delay: the more usual ones include design flaws, government regulations, finance problems and sponsor management. All the above risks would have an adverse effect on a portfolio’s economic parameters (Leiringer 2003).
5.8.2 Currency Risk
This arises when there is a cross-border flow of funds. With the collapse of fixed parities in the early 1970s, exchange rates of currencies are free to fluctuate according to the supply and demand for different currencies. The operation of speculators in the money market has added to the volatility of the exchange rates. Foreign exchange transactions involving any currency are therefore subject to currency risk (Merna 2002). In some cases, however, if an entity has a foreign currency payment and can match this payment with currency receivable, then the net exposure is zero. A convertible currency is one which can be freely exchanged for other currencies or gold without special authorisation from the appropriate central bank. The introduction of the euro to most EU countries has reduced currency risk for companies trading within these economies (Merna 2002).
5.8.3 Interest Rate Risk
Interest rate risk directly affects both the borrowing and the investing entity. The exposure depends on the maturity of the funds raised and developments in the financial market from where the funds have been raised.
Interest rate risk can broadly be classified in two categories. Firstly, risk on securities or financial instruments which are used for raising short-term finance. These facilities mature during a short period. Interest rate risks on these facilities largely depend on developments in the money market. Secondly, financial instruments which have a longer maturity, but where the longer period is split into smaller periods (Tinsley 2000).
5.8.4 Equity Risk
Equity risk is derived from the rise and fall of share prices which affect the entity holding the instrument. They also, however, affect company shares which are publicly quoted. Such companies may find it difficult to raise finance if the market price of their shares significantly falls in value (Logan 2003).
5.8.5 Corporate Bond Risk
Corporate bonds which are junior to debt and senior to equity in terms of call on the business assets are issued by corporate bodies to raise funds for investment; the funds raised may be used to inject capital into a project or portfolio. Bonds are credit rated by S&P and Moody’s. For example, if they award an AAA rating it means the bond is almost as safe as a government stock; these would be classed as high-grade bonds. Medium-grade bonds would be rated A, speculative grade bonds would be rated B and high-risk bonds, often referred to as junk bonds, rated E. The rating of a bond is determined by the risk associated with the organisation and the business to be funded by the bond. Clearly, corporate bodies must know the risks associated with an investment, as must the rating agencies. Project risk and business risk must therefore be addressed before bonds are rated and issued (Merna and Dubey 1998, Khu 2002).
5.8.6 Liquidity Risk
Liquidity risk is an outcome of commercial risk. If a project or portfolio is not able to generate sufficient resources to meet its liabilities it enters into liquidity risk. Liquidity risk is the potential risk arising when an entity cannot meet payments when they fall due. It may involve borrowing at excessive rates of interest, or selling assets, in some cases projects within a portfolio, at below market prices. Liquidity risk is extremely important because most of the borrowing, whether loan or bond, has a ‘cross-default’ clause. This means that if the organisation has defaulted on any of its obligations then a debt with a ‘cross-default’ clause may be called back by lenders for immediate repayment. If this provision is triggered then the organisation may face even more liquidity problems and may be forced to declare bankruptcy. Liquidity risk is generally described as a cash flow problem (Khu 2002).
5.8.7 Counter-party Risk
Any financial transaction involves two or more parties, and the parties run the potential risk of default by the other parties. This is known as counter-party risk. For example, if an organisation has a tied line of credit from a bank or a financial institution then it runs the risk of the lender not being able to meet its commitments in providing the funds at the right time. On the other hand, after the loan has been dispersed the lender runs the risk of default in repayment and interest payment by the borrower. The magnitude of the counter-party risk depends on the size of all outstanding positions with a particular counter-party and whether or not any netting arrangement is in force (Galitz 1995, Smithson 1998).
Fraser et al. (1995) also covers risks identified by Merna and Njiru (1998), but defines the following risks specific to the banking sector:
• Credit risk. The risk that the bank will not get its money back (or payment will be delayed) from a loan or an investment. This has been the cause of most major bank failures over the years.
• Operational risk. The risk that operating expenses, especially noninterest expenses such as salaries and wages, might be higher than expected. Banks that lack the ability to control their expenses are more likely to have unpleasant earning surprises. Over an extended
• time in a competitive market environment, banks with excessively high operating costs will have difficulty surviving.
• Capital risk. The risk of having inadequate equity capital to continue to operate. This may be viewed either from an economic perspective so that inadequate equity capital occurs when customers refuse to leave their funds with the bank (causing a liquidity crisis), or from a regulatory perspective (where the bank regulatory authorities close the bank because capital is below regulatory minima).
• Fraud risk. The risk that officers, employees or outsiders will steal from the bank by falsifying records, self-dealing or other devices. Fraud risk is associated with unsound banking processes that could result in bank failure.
5.8.8 Maintenance Risk
Maintenance risk arises when the completed project does not function efficiently. Operating risks include the operator’s experience and resources, supply of skilled labour, and other party risk (Khu 2002).
5.8.9 Taxation Risk
Profits made within a country are subjected to tax. Promoters will most probably include the cost of paying these taxes in their model. However, the models often do not take into account tax increases, and if they do occur they could seriously compromise the project (Merna and Njiru 1998).
5.8.10 Reinvestment Risk
Reinvestment risk results from the fact that interest or dividends earned from an investment may not be able to be reinvested in such a way that they will earn the same rate of return as the invested funds which generated them. For example, falling interest rates may prevent bond coupon payments from earning the same rate of return as the original bond (Fabozzi 2002).
5.8.11 Country Risk
A large number of projects are undertaken by corporate and strategic businesses in overseas countries (Ariani 2001). Hefferman (1986) defines country risk as ‘the risk associated with publicly guaranteed loans or loans made directly to a foreign government’; however, this is a very narrow definition. The identification of country risks is discussed in Chapter 4.
5.9 NON-FINANCIAL RISKS AFFECTING PROJECT FINANCE
These risks also affect the shape of the cumulative cash flow and therefore the commercial viability of a project or portfolio. The risks include:
• dynamic risk
• inherent risk
• contingent risk
• customer risk
• regulatory risk
• reputation/damage risk
• organisational risk
• interpretation risk.
• interpretation risk.
5.9.1 Dynamic Risk
Dynamic risk is concerned with maximising opportunities. Dynamic risk means that there will be potential gains as well as potential losses: that is, risking the loss of something certain for the gain of something uncertain. Every management decision has the element of dynamic risk governed only by practical rules of risk taking. During a project, losses and gains resulting from risk can be plotted against each other (Flanagan and Norman 1993, Merna 2002).
5.9.2 Inherent Risk
The way in which risk is handled depends on the nature of the business and the way that business is organised internally. For example, energy companies are engaged in an inherently risky business – the threat of fire and explosion is always present, as is the risk of environmental impairment. Financial institutions on the other hand have an inherently lower risk of fire and explosion than an energy company, but they are exposed to different sorts of risk. However, the level of attention given to managing risk in an industry is as important as the actual risk inherent in the operations which necessarily must be performed in that industry activity. For example, until very recently repetitive strain injury (RSI) was not considered to be a problem; however, it is now affecting employers’ liability insurance (International Journal of Project Business Risk Management 1998). Another example is Gulf War syndrome.
5.9.3 Contingent Risk
Contingent risk occurs when an organisation is directly affected by an event in an area beyond its direct control but on which it has a dependency, such as weak suppliers (International Journal of Project Business Risk Management 1998). Normally a percentage of the overall project value is put aside to cover the costs of meeting such risks should they occur.
5.9.4 Customer Risk
Dependency on one client creates vulnerability because that client can take its business away, or be taken over by a rival. The risk can be managed by creating a larger customer base (International Journal of Project Business Risk Management 1998).
5.9.5 Regulatory Risk
Only by keeping abreast of potential changes in the environment can a business expect to manage these risks. Recent examples in the UK include awards to women for discrimination in the armed forces, RSI and windfall profits tax in exceptional years (International Journal of Project Business Risk Management 1998, Merna 2002). In October 2001, Railtrack Plc, a company listed on the London Stock Exchange, was put into administration by the UK Transport Secretary without any consultation with its lenders or shareholders. Shareholders taking the usual risks of rises and falls in stock market value were quickly made aware of a new type of risk (Merna 2002).
5.9.6 Reputation/Damage Risk
This is not a risk in its own right but rather the consequence of another risk, such as fraud, a building destroyed, failure to attend to complaints, lack of respect for others. It is the absence of control which causes much of the damage rather than the event itself. In a post-disaster situation an organisation can come out positively if the media are well handled (Leiringer 2003).
5.9.7 Organisational Risk
A poor infrastructure can result in weak controls and poor communications with a variety of impacts on the business. Good communication links will lead to effective risk management (Borge 2001).
5.9.8 Interpretation Risk
This occurs where management and staff in the same organisation cannot communicate effectively because of their own professional language (jargon). Engineers, academics, chemists and bankers all have their own terms, and insurers are probably the worst culprits, using words with common meanings but in a specialised way. Even the same words in the same profession have different meanings in the UK and the USA.
5.10 MANAGING FINANCIAL RISKS
There are various methods of managing risks. The following number of risks associated with financial options, and possible means of mitigation, are discussed below:
• construction delay
• currency risk
• interest rate risk
• equity risk
• corporate bond risk
• liquidity risk
• counter-party risk
• maintenance risk
• taxation risk
• reinvestment risk
• country risk.
5.10.1 Construction Delay
A promoter can edge construction risk by using fixed price contracts, typically lump sum turnkey contracts, and impose liquidated damages on the contractors if they fail to complete a project on time. However, if performance is better than expected the contractors could be awarded bonuses. In most circumstances liquidated damages cover additional interest repayments arising through delay, and compensate equity investors for lost income and fixed costs incurred. However, Ruster (1996) states that liquidated damages are always capped at a certain percentage of the contract price (usually 10-15%).
The sponsor can also include contingency funds in the construction budgets to cover unexpected cost increases. In some cases the promoter will arrange for a standby loan to cover additional costs that may arise in construction or early operation of the project. Standby loans are expensive to arrange and service and should be avoided if cheaper loans are available to cover such costs (Merna and Smith 1996).
Insurance is another way of managing construction risk. Insurance cover ranges from employee liability to acts of God.
5.10.2 Currency Risk
Fluctuations in exchange rates can cause problems if the revenue generated from a project is in local currency and the loan repayment is in a foreign currency. If the value of the local currency depreciates against the value of the foreign currency then the promoter would have to exchange more local currency in order to service the debt, therefore eating into the profits of the project and affecting its commercial viability (Ariani 2001). There are several financial engineering techniques a promoter can use to manage currency risk (Khu 2002) as follows.
5.10.2.1 Currency Forward Exchange
This eliminates risk by fixing the exchange rate at which future trade will take place. A forward contract is made which states the exchange rate for several future payments at the current rate. The contract provides an edge against future fluctuations in the currencies the project is dealing with.
5.10.2.2 Currency Swaps
These are another way of managing risk. The promoter borrows in a hard currency and finances the project in the local currency. The promoter can enter into an agreement whereby the hard currency is swapped for the local currency, allowing hard currency financing.
5.10.2.3 Currency Options
This method of risk reduction is to fix the exchange but give the promoter an option to buy from the open market if the rates are favourable to the company.
5.10.2.4 Use Local Currency
The use of local currency in developing countries to finance projects can be an advantage because it reduces the project’s reliance on foreign currency.
5.10.3 Interest Rate Risk
Volatility in interestrates can have significant consequences for an organisation /promoter. However, financial engineering techniques have been developed in the derivatives market to compensate for this problem. These techniques include the following.
5.10.3.1 Interest Rate Forward Agreement (FRA)
These agreements are similar to futures contracts, although, according to Glen (1993), they do have other advantages. These are that FRAs are customised so that the maturity and amount can be written to correspond more to the risk exposure, and FRAs are agreed with the local bank, which means creditworthiness is easier to prove. Consider as an example of an FRA a promoter who wants to borrow £5 million in six months’ time when the current loan has been paid, but the promoter expects the rate of interest to rise. This expected rise in interest rates can be compensated for by arranging the FRA now, for the loan it will buy in six months’ time.
5.10.3.2 Interest Rate Swap
An interest rate swap is an agreement between two parties to pay each other a series of cash flows, based on fixed or floating interest rates, in the same currency, over a given period of time.
Suppose that a company has assets which produce a fixed stream of income unrelated to fluctuations in interestrates. To finance its activities, the company borrows funds at a floating rate. This creates a mismatch between its income (which is constant) and its outgoings (which fluctuate with changes in interest rates).
To protect against this mismatch risk, the company can enter into an interest rate swap. It will pay the swap counter-party a fixed rate and receive from the swap counter-party a payment which fluctuates with floating rates, which it can then use to service its floating rate borrowings. The principal amounts are not usually exchanged and are expressed to be notional. The parties typically agree to settle the payments on a net basis, with the party owing the larger amount paying the excess to the other.
5.10.3.3 RPI Swaps
An inflation-linked or Retail Price Index-linked (RPI) swap allows parties to manage the risk of inflation being higher or lower than expected.
Suppose a company is in receipt of a series of fixed equal cash flows. While the investor is certain of the magnitude of the flows, the investor is concerned that the purchasing power of the flows will erode through inflation. To hedge this risk he enters into an RPI swap in which he pays the swap counter-party the fixed flows and receives in return another flow linked to RPI. With this swap, the investor has given up his certain cash flow for a cash flow that will have the same purchasing power through time.
One of the most popular types of RPI swap is the real rate swap. This is similar to an interest rate swap, except that it uses ‘real’ interest rates, that is net of inflation, rather than nominal interest rates (the ordinary percentage figure). With this type of swap, a party, such as a pension fund, can invest in a portfolio of fixed-rate bonds and swap the fixed cash flows from the bonds for cash flows that match the timing and inflation characteristics of its pension outgoings.
5.10.3.4 Caps and Floors
These can reduce risk. For example, the promoter agrees a term loan with a bank of LIBOR + 2%. The promoter also buys a cap for 7% and sells a floor for 5%, creating a collar. Under this agreement the promoter can pay no higher than 7% if interest rates rise. However, if the interest rate falls below 5% the promoter would have to pay the difference (Khu 2002).
5.10.4 Equity Risk
Equity risk can be managed either through reinsurance, or through hedging. For the issuer of the equity the risk of changes in the price of equity is not direct but indirect. The market price of the equity is a rough barometer of the health of the organisation. If the organisation has been performing well or has a good potential for better performance then the market price of the equity of such an organisation will be high. More and more investors will like to own the shares of such a organisation. It will provide good potential to raise additional funds either through the issue of more equities or through debt instruments. Whereas the investors in the equity can use the financial engineering instruments to manage their risk, the issuers of the equity are not permitted to deal in their own shares because they have internal information about the organisation which may tempt them to indulge in undue speculation at the cost of the owners of the equity, who do not have access to such information. However, sometimes organisations in need of funds when their equity price is falling resort to issuing bonus shares to the existing equity owners at below market price to retain the interest of these investors in the organisation and also to raise resources. In the long run the organisation must show good results if it wants its equity to perform well (Cornell 1999).
5.10.5 Corporate Bond Risk
A convertible bond gives the holder of the bond the right to exchange it for a given number of shares before the bond matures. Changing the instrument from debt to equity will change the gearing of the company. When the company is not doing well it will prefer a low gearing ratio. However, in an ideal world the holders of convertible bonds would like to retain the bond and not change it to equity because it could reduce their investment (Merna and Dubey 1998).
5.10.6 Liquidity Risk
Successful management of the liquidity risk hinges on successful cash management of the project. Delays in construction and commissioning, problems with the operation of the project and problems of input supplies and off-take of the produce may lead to unmatched cash inflows and cash outflows and hence liquidity risk.
The problem of liquidity due to cost overruns can be managed by arranging a standby loan. Although standby loan facilities are expensive compared with the normal type of loan, they provide a safety net in the case of cost overruns.
Another method of managing liquidity risk is debt-equity swap. If the liquidity problem is for a short period and the project has a good potential of success then the providers of debt capital may agree to convert their debt into equity. This gives them an opportunity to share in the profits of the company in the future. Conversion of debt to shares totally changes the nature of liability of the company. With shares, the company needs to pay the shareholders only when a dividend is declared. This helps manage the liquidity of the company but at the cost of reduced gearing. Debt for equity swaps have been considered for the Channel Tunnel (Merna and Smith 1996).
Liquidity management is governed by eight key principles:
1. Developing a structure for managing liquidity.
2. Measuring and monitoring net funding requirements.
3. Managing market access.
4. Contingency planning.
5. Foreign currency liquidity management.
6. Internal controls for liquidity risk management.
7. The role of public disclosure for improving liquidity.
8. Supervision.
5.10.7 Counter-party Risk
Controlling counter-party risk is done through both parties involved in the project by monitoring their credit risks and only releasing funds on completion of the other party’s obligations (Smithson 1998, Galitz 1995).
5.10.8 Maintenance Risk
Operation of the project by a reputable and financially sound operator whose performance is guaranteed should minimise maintenance risk. However, other ways of hedging operation risks include agreements with equipment and input suppliers, business interruption insurance, and loss of profit insurance in the early years of operation (Tinsley 2000).
5.10.9 Taxation Risk
Taxation is an external influence which is beyond the control of the promoter. Tax regimes greatly influence the commercial viability of a project. However, governments can attract foreign promoters by offering exemption from corporate tax for concessional periods (tax holidays), and fixed tax structures for the concessional period (Merna and Njiru 1998).
5.10.10 Reinvestment Risk
The present authors suggest that when investing returns from a project or portfolio a careful analysis must be made to ensure that future investments will generate higher returns than they would from being reinvested in the original project or portfolio. Surplus cash generated from a portfolio of projects can be used for cross-collateralisation or invested in other commercially viable ventures.
5.10.11 Country Risk
The risks associated with investing in different countries can only be managed through a complete country risk assessment before the project is sanctioned. This will allow possible risks to be identified and analysed. Contingencies can then be put in place in the event of the risk transpiring. However, the risk analysis could highlight the fact that the project carries too many risks and therefore would not be sanctioned (Merna 2002, Ariani 2001).
To eliminate country risk it is important that the government takes prime responsibility to provide security through the duration of the project (Nagy 1979).
5.11 RISK MODELLING
Alabastro et al. (1995) define a model as a simplified representation of a complex reality. Modelling is the act of developing an accurate description of a system (Jong 1995). A model means to understand.
Computers are fast and efficient tools for evaluating data but it is important that the users should not lose sight of the assumptions on which software packages are based. The output from a computer model is determined by the information input, which means that accurate data are essential. The idea that if the computer has produced something then it must be right is a belief held by too many people and is certainly not true.
It is essential that the software should fit the project rather than the modeller attempt to fit the project to the software. Software tools should be matched to the kind of project work that is undertaken by an organisation and the way that the organisation manages its projects. The choice of software, for use in project modelling, is very important and requires careful consideration.
It is difficult to find ‘off-the-shelf’ risk management programs that match the project or portfolio characteristics and the project manager’s needs. The majority of programs that are available off the shelf for commercial use are designed to meet the needs of many different types of businesses. Although these programs are user-friendly they tend to lack the modelling flexibility that is required.
There are many advantages in using a computer to model a project or a portfolio. Listed below are some of the more significant ones (Smith 1999):
• Flexibility. Computers are very flexible in the way in which they can accept information, enabling most projects to be modelled using a computer. The programs used to model projects can be either off-the-shelf packages or tailored to the needs of the user (bespoke).
• Speed and accuracy. When the complexity of a model is such that no manual analytical technique can be used, computers often provide the only means available for modelling. A computer can carry out many complex calculations very quickly, compared with humans, and reliance can be placed on the accuracy of the calculations. This combination of accuracy and speed is essential for most of the probabilistic risk analysis techniques.
• Additional reality. Computer simulation enables real-life complications, such as exchange rates, inflation rates and interest rates, to be included in the project model, and to calculate their effect on the project’s economic parameters.
• Assistance in the decision-making process. The project model enables a number of ‘what if’ questions and possible scenarios to be simulated, and shows the effects in terms of the outcome of the project. This simulation process shows the way in which the project is expected to react to certain events or changes and allows contingency plans to be drawn up that can be used in the event that any of the scenarios occur.
• Scenario analysis. Often there are no historical data available, from a similar project or portfolio, that relate to the project/portfolio scenarios drawn up by the project organisers, so computer simulation is the only way to see how the project or portfolio might react to particular scenarios.
• Reduced dependence on raw judgement. Few people have a reliable intuitive understanding of business risk, and risk modelling removes the reliance on this intuition. A model provides a structure for the project and outputs, which, although based on subjective inputs, gives a basis for decision making.
There are a number of limitations to using a computer to model a project or portfolio. Listed below are some of the more significant ones:
• Poor data lead to an inaccurate model. A model of a project is only as good as the data that are input, so if these data are inaccurate then the model will not accurately reflect the project.
• The model is not representative of the actual project. Even if the data are accurate, it is possible for an inexperienced modeller to create a model that is not representative of the actual project. It is necessary for the project modeller to have a thorough understanding of the particular project to be modelled in order to create a representative model.
• It is too easy to create inaccurate models. Project modelling programs are designed to be user-friendly, which increases the dangers associated with the inexperienced/novice modeller.
• There is a heavy reliance on subjective judgement. The data may not always be available when the project is being modelled, and some subjective assumptions may have to be made in order to complete the model. So as a result of the data requirement, a heavy reliance is placed on subjective assumptions and personal judgement. This is particularly the case when modelling the project variables or risks.
• Inability fully to reflect real-life complications. The model produced is only a mathematical representation of real life and, therefore, does not necessarily accurately reflect the reaction of the actual project or portfolio to real-life complications. It is impossible to be sure that the model will react in exactly the same way as the real project, because the project does not yet exist and everything is based on what is expected to happen (unless the project being modelled is identical to a previous project or portfolio).
• Reliance on computer output. Too much reliance is placed on the output from computers and often there is insufficient checking of the model or the program used to create the model. It is difficult to tell whether a project model is an accurate representation of reality or not. If the model is very inaccurate it will be easily detected, but if it is nearly accurate then this is much more difficult to detect. It is in situations where the model is almost, but not exactly, accurate that problems arise, because the model does not react to real-life complications in the same way that the actual project would (Ould 1995).
5.12 TYPES OF RISK SOFTWARE
Many of the risk management software packages available that have the capabilities to perform quantitative probability analysis generally use a random number generator based on either the Monte Carlo or the Latin Hypercube systems. Network packages also employ Markovian logic so that the interdependence of project activities on the identified risks may be simulated.
The types of risk software are described below.
5.12.1 Management Data Software Packages
These tend to be large software systems based around database material. Essentially they are designed to process data and are therefore concerned predominantly with the automating of administrative work. They may be tailored for a specific application or be general in nature, depending upon the users’ requirement. These software packages are expensive to purchase. They are suitable if there is an adequate database from which information can be fed to the system; however, generally at the present time the majority of companies do not have the necessary database to make these programs economically and practically viable.
5.12.2 Spreadsheet-based Risk Assessment Software
This group of programs are used in the evaluation of risk in models which are designed to carry out analysis for specific analytical requirements. These programs are generally add-in programs, that is programs that are normally macro programs which are specifically designed to combine with commercially marketed, proprietary software packages; they import risk assessment analysis capabilities within the receiving program.
5.12.3 Project Network-based Risk Assessment Software
This group of programs are also used in the evaluation of risk in models which are designed to carry out analysis for specific analytical requirements. These programs may be add-in or stand-alone programs. Add-in programs are normally macro programs specifically designed to combine with commercial software and import risk assessment analysis capabilities within it.
5.12.4 Standalone Project Network-based Risk Assessment Software
This type of software is intended to be self-contained in terms of the construction of the risk model, the parameters and the variables that are input. These programs also produce the required output of the risk analysis results and can generate comprehensive reports contained within the program or they may be exported to other software packages if necessary.
5.13 SUMMARY
Raising finance for projects is an important issue. Without finance the project cannot go ahead. Therefore organisations/promoters need to determine the sources of finance available.
Figure 5.3 Seniority of financial instruments
This chapter briefly described both corporate and project finance. It also discussed the types of financial instruments that are used as a source of finance. The seniority of these instruments, in terms of their claims on project assets in the event of default, are illustrated in Figure 5.3.
Debt is the most used instrument to fund projects. With debt there is an interest charge on the loan. Bond issues are becoming popular amongst promoters to raise project finance. Projects worldwide have been funded partly by bonds. Equity is considered as risk capital because investors bear a higher degree of risk than other lenders. Equity ranks the lowest in terms of its claim on the assets of the project.
The debt-equity ratio assigned to a project investment is a measure of the risk in that project investment. The greater the equity issue, the greater the perceived risk.
Risk management involves identifying risks, predicting how probable they are and how serious they might become, deciding what to do about them and implementing these decisions.
Major risks associated with finance include construction risk, currency risk, interest rate risk, equity risk, liquidity risk, counter-party risk, maintenance risk and taxation risk. There are different ways to manage these risks, for example financial engineering techniques prove to be an excellent way to manage currency and interest rate risks.
Modelling risk is an important element of the risk analysis process and should only be performed with data that reflect the investment in terms of cost and time. The choice of risk management software is paramount to a successful risk assessment. Risk management software is readily available and numerous programs have been developed to assess project risk. The key is finding the right software for the project in hand.
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