Discuss the meaning and importance of project finance. Discuss the various sources of project financing and financial institutions structure in India

Ans. Finance is the lubricant of the process of economic growth. When finance mode is available, industrial activities can be initiated which gives rise to new investment opportunities towards industrialization. The Indian financial institutions have been very important constituent of the Indian economy. This importance they have derived from their financial muscle and they have linked it to the industrial development in the country. For years now the Indian financial institutions have been the life line of credit for the Indian corporate. This has been mainly because of their strong financial muscle and the various concessions they received from the Central Government for their role.

In India, special financial institutions have been developed to provide finance to the upliftment of industrial activities in all regions so as to sustain an equitable industrial growth in the county. Financial assistance is being extended to the industrial enterprises by the financial institutions and development banks on confessional terms of finance as per their bye laws in the state.

Meaning and importance of project finance

Project finance refers to the financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash flow generated by the project.Project finance is used by private sector companies as a means of funding major projects off balance sheet. At the heart of the project finance transaction is the concession company, a special purpose Vehicle (SPV) which consists of the consortium shareholders who may be investors or have other interests in the project (such as contractor or operator). The SPV is created as an independent legal entity which enters into contractual agreements with a number of other parties necessary in the project finance deals.

The attractiveness of project finance is the ability to fund projected in the off balance sheet with limited or non-recourse to the equity investors i.e. if a project fails, the project lenders recourse is to ownership of the actual project and they are unable to pursue the equity investors for debt. For this reason lenders focus on the projects cash flow as the main source for repaying project debt.

Importance of Project finance

Project financing is being used throughout the world across a wide range of industries and sectors. This funding technique is growing in popularity as governments seek to involve the private sector in the funding and operation of public infrastructure. Private sector investment and management of public sector assets is being openly encouraged by governments and multilateral agencies who recognize that private sector companies are better equipped and more efficient than government in developing and managing major public services.

Project finance is used extensively in the following sectors.

Oil and gas

Mining

Electricity Generation

Water

Telecommunications

Road and highways

Railways and Metro systems

Public services

Sources of Project Finance

Finance is the lubricant of the process of economic growth. When finance mode is available, industrial activities can be initiated which gives rise to new investment opportunities towards industrialization. The Indian financial institutions have been very important constituent of the Indian economy. This importance they have derived from their financial muscle and they have linked it to the industrial development in the country The long-term sources of finance used for meeting the cost of project are referred to as the means of finance. To meet the cost of project, the following

sources of finance may be available :

Equity Capital

Preference Capital

Debentures

Rupees term loans

Foreign currency term loans

Euro issues

Deferred credit

Bill rediscounting scheme

Suppliers line of credit

Seed capital assistance

Government subsidies

Sales tax deferment and exemption

Unsecured loans and deposits

Lease and hire purchase finance

Public Deposit

Bank Credit

Equity Capital

This is the contribution made by the owners of business, the equity shareholders, who enjoy the rewards and bear the risks of ownership. However, their liabilities, limited to their capital contribution. From the point of view of the issuing film, equity capital offers, two important advantages: (i) It represents permanent capital. Hence there is no liability for repayment. (ii) It does not involve any fixed obligation for payment of dividend. The disadvantages of raising funds by way of equity capital are : (i) The cost of equity capital is high because equity dividend are not tax-deductible expenses. (ii) The cost of issuing equity capital is high.

Preference Capital

A hybrid form of financing, preference capital partakes some characteristics of equity capital and some attributes of debt capital. It is similar, to equity capital because preference dividend, like equity dividend, is not a tax-deductible payment. It resembles debt capital because the rate of preference dividend is fixed. Typically, when preference dividend is skipped it is payable in future because of the cumulative feature associated with it. The near-fixity of preference dividend payment renders preference capital somewhat unattractive in general as a source of finance. It is, however, attractive when the promoters do not want a reduction in their share: share of equity and yet there is need for widening the net worth base (net worth consists of equity and preference capital) to satisfy the requirements of financial institutions. In addition to the conventional preference shares, a company may issue Cumulative Convertible Preference Shares (CCPS). These shares carry a dividend rate of 10 per cent (which; if unpaid, cumulates) and are compulsory convertible into equity shares between three and five years from the date of issue.

Debenture Capital

In the last few years, debenture capital has emerged as an important source for project financing. There are three types of debentures that are commonly used in India: Non-Convertible Debentures (NCDs), Partially Convertible Debentures (PCDs), and Fully Convertible Debentures (FCDs). Akin to promissory, NCDs are used by companies for raising debt that is generally retired over a period of 5 to 10 years. They are secured by a charge on the assets of the issuing company. PCDs are partly convertible into equity shares as per pre-determined terms of conversion. The unconverted portion of PCDs remains like NCDs. FCDs, as the name implies, are converted wholly into equity shares as per pre-determined terms of conversion. Hence FCDs may be regarded as delayed equity instruments.

Rupee Term Loans

Provided by financial institutions and commercial banks, rupee term loans which represent secured borrowings are a very important source for financing new projects as well as expansion, modernisation, and renovation schemes of existing units. These loans are generally repayable over a period of 8-10 years which includes a moratoriumperiod of l-3 years.

Foreign Currency Terms Loans

Financial institutions provide foreign currency term loans for-meeting the foreign currency expenditures towards import of plant, machinery, equipment and also towards payment of foreign technical know-how fees. Under the general scheme, the periodical liability towards interest and principal remains in the currency/currencies of the loan/ s and is translated into rupees at the then prevailing rate of exchange for making payments to the financial institution. Apart from approaching financial institutions (which typically serve as intermediaries between foreign agencies and Indian borrowers), companies can directly obtain foreign currency loans from international lenders. More and more companies appear to be doing so presently.

Euro issues

Beginning with Reliance Industries’ Global Depository Receipts issue of approximately $150 ml in May 1992, a number of companies have been making euro issues. They have employed two types of securities: Global Depository Receipts (GDRs) and Euroconvertible Bonds (ECBs). Denominated in US dollars, a GDR is a negotiable certificate that represents the publicly traded local currency (Indian Rupee) equity shares of a non-US (Indian) company. (Of course, in. theory, a GDR may represent a debt security; in practice it rarely does so.) GDRs are issued by the Depository Bank (such as the Bank of New York) against the local currency shares (such as Rupee shares) which are delivered to the depository’s local custodian banks. GDRs trade freely in the overseas markets. A Euroconvertible Bond (ECB) is an equity-linked debt security. The holder of  an ECB has the option to convert it into equity shares at a pre-determined conversion

ratio during a specified period. ECBs are regarded as advantageous by the issuing company because (i) they carry a lower rate of interest compared to a straight debt security, (ii) they do not lead to dilution of earnings per share in the near future, and (iii) they carry very few restrictive covenants.

Deferred Credit

Many a time the suppliers of machinery provide deferred credit facility under which payment for the purchase of machinery is made over a period of time. The interest rate on deferred credit and the period of payment vary rather widely. Normally, the supplier of machinery when he offers deferred credit facility insists that the bank guarantee should be furnished by the buyer.

Bills Rediscounting Scheme

Operated by the IDBI, the bills rediscounting scheme is meant to promote the sale of indigenous machinery on deferred payment basis. Under this scheme, the seller realizes the sale proceeds by discounting the bills or promissory notes accepted by the buyer with a commercial bank which in turn rediscounts them with the IDBI. This scheme is meant primarily for balancing equipments and machinery required for expansion, modernisation, and replacement schemes.

Suppliers’ Line of Credit

Administered by the ICICI, the Suppliers’ Line of Credit is somewhat similar to the IDBI’s Bill Rediscounting Scheme. Under this arrangement, ICICI directly pays to the machinery manufacturer against usance bills duly accepted or guaranteed by the bank of the purchaser.

Seed Capital Assistance

Financial institutions, through what may be labelled broadly as the ‘Seed Capital Assistance scheme, seek to supplement the resources of the promoters and of medium scale industrial units which are eligible for assistance from All-India financial institutions and/ or state-level financial institutions. Broadly three schemes have been formulated:

(i) Special Seed Capital Assistance Scheme The quantum of assistance under this scheme is Rs 0.2 million or 20 per cent of the project cost, whichever is lower. This scheme is administered by the State. Financial Corporations.

(ii) Seed Capital Assistance Scheme The assistance order this scheme is applicable to projects costing not more then Rs 20 million. The assistance per project is restricted to Rs 1.5 million. The assistance is provided by IDBI through state level financial institutions. In special cases, the IDBI may provide the assistance directly.

(iii) Risk Capital Foundation Scheme Under this scheme, the Risk Capital Foundation,an autonomous foundation set up and funded by the IFCI, offers assistance to promoters of projects costing between Rs 20 million and Rs 150 million. The ceiling on the assistance provided between Rs 1.5 million and Rs 4 million depending on the number of applicant promoters.

Government Subsidies

Previously the central government as well as the state governments provided subsidies to industrial units located in backward areas. The central subsidy has been discontinued but the state subsidies continue. The state subsidies vary between 5 per cent to 25 per cent of the fixed capital investment in the project, subject to a ceiling varying between Rs 0.5 million and Rs 2.5 million depending on the location.

Sales Tax. Deferments and Exemptions

To attract industries, the states provide incentives, inter alia, in the form of sales tax deferments and sales tax exemptions. Under the sales tax deferment scheme, the payment of sales tax on the sale of finished goods may be deferred for a period ranging between five to twelve years. Essentially, it implies that the project gets an interest free loan, represented by the quantum of sales tax deferred, during the deferent period.

Under the sales tax exemption scheme, some states exempt the payment of sales tax applicable on purchases of raw materials, consumables, packing, and processing materials from within the state which are used for manufacturing purposes. The period of exemption ranges from three to nine years depending upon the state and the specific location of the project within the state.

Unsecured Loans and Deposits

Unsecured loans are typically provided by the promoters to fill the gap between the promoters’ contribution required by financial institutions and the equity capital subscribed by the promoters. These loans are subsidiary to the institutional loans. The rate of interest chargeable on these loans is less than the rate of interest on the institutional loans. Finally these loans cannot be taken back without the prior approval of financial institutions. Deposits from public, referred to as public deposits, represent unsecured borrowing of two to three years’ duration. Many existing companies prefer to raise public deposits instead of term loans from financial institutions because restrictive covenants do not accompany public deposits. However, it may not be possible for a new company to raise public deposits. Further, it maybe difficult for it to repay public deposits within three years.

Foreign Currency Loans

Apart from rupee term loans, financial institutions provide foreign currency loans. This assistance is now provided only for the import of capital equipment (as per the liberalised exchange risk management system, foreign currency required for other purposes has to be purchased from authorised dealers at market rates). On foreign currency loans sanctioned under the general scheme, the interest rate charged is typically  a floating rate as determined by the lenders, (the foreign agency that has given a line of credit to the financial institution for onward lending) and the risk of exchange rate fluctuation is born by the borrower. On foreign currency loans sanctioned under the Exchange Risk Administration Scheme, the principal repayment obligations of the borrower are rupee tied at the rate of exchange prevailing on the dates of disbursement.

On such rupee-tied loan liability, the borrower pays by way of servicing his loan a composite, cost every quarter. The composite cost consists of three elements: (i) the interest portion which is arrived on the basis of the weighted average interest cost of the various components of the currency pool, (ii) the spread of the financial institutions, and (iii) the exchange risk premium. The ‘composite cost’ is a variable rate determined at six-monthly intervals. It has a floor and a cap. Both the floor and the cap as well as the rate of interest applicable for the period is reviewed and announced from time to time.

Leasing and Hire Purchase Finance

With the emergence of scores of finance companies engaged in the business of leasing and hire purchase finance, it may be possible to get a portion, albeit a small portion, of the assets financed under a lease or a hire purchase arrangement. Typically, a project is financed partly by financial institutions and partly through the resources raised from the capital market. Hence, in finalising the financing scheme for a project, you should bear in mind the norms and policies of financial institutions and the guidelines of Securities Exchange Board of India and the requirements of the Securities Contracts Regulation Act (SCRA).

Public Deposit

Public deposits have been a peculiar feature or industrial finance in India. Companies have been receiving public deposits for a long time in order to meet their medium-term and long-term requirements for finance. This system was very popular in the cotton textile mills or Bombay, Ahmedabad and Sholapur and in the tea gardens or Assam and Bengal. In recent years, the method or raising finance through the public deposits has again become popular for various reasons. Rates or interest offered by the companies are higher than those offered by banks. At the same time the cost of deposits to the company is less than the cost or borrowings from banks. While accepting public deposits, a company must follow the provisions or the companies Act and the directions issued by the Reserve bank of India. According to the companies (Acceptance of Deposits Rules, 1975 as amended in 1984) Act, no company can receive secure and unsecured deposits in excess of 10% and 25% respectively of paid up share capital plus free reserves. The Central Government has laid down that no company shall invite a deposit unless an advertisement, including a statement showing the financial position of the company, has been issued in the prescribed form. Under the new rule, deposits can be renewed. The rate of interest payable on deposits must not exceed 15% per annum. In order to repay the deposits maturing in a particular year, the company must deposit 110% or the deposits with a scheduled bank or in specified securities.

Bank Credit

Commercial banks in the country serve as the single largest source or shortterm finance to business firms. They provide it in the form of Outright Loans. Cash credit, and Lines of Credit.