The document discusses project financing and appraisal, explaining that project financing deals with how to finance projects while project appraisal focuses on evaluating which projects are worth financing. It covers the different approaches to project financing and appraisal, from the promoter and lender perspectives, and examines factors like the macroeconomic environment, institutional framework, and why markets may fail in regards to financing public goods projects.

1. PROJECT FINANCING AND
APPRAISAL
September 21, 2006

2. Project Financing and Appraisal
• Project Financing and Project Appraisal are two
sides of the same coin.
– Project Financing deals with how one would finance
projects.
– Project Appraisal focuses on how does one evaluate
projects to know which projects are worth financing.
– The promoter’s view vis a vis the lender’s view: project
finance means financing an investment based on the
operating cash flows and assets, generally without
sponsor guarantees.
– Corporate finance vs. project finance (recourse and
non-recourse)

3. Project Finance: Macro and the
Micro Approach
• One way of posing the project finance question is to ask
for instance:
– Why did Sub- Saharan Africa attract only 5% of the world’s
investments.
– Why did Africa rank last among developing regions in investment
flows to projects, with US$39.4 billion in 1990–2004, far behind
Latin America (US$391 billion) and East Asia (US$199 billion).
– Why did South Africa and Nigeria together account for about two
third of these flows in 1990–2004.
– Why did South Africa alone manage to receive 50% (US$19
billion) of these flows.
– How does China spend above 10% of GDP on infrastructure and
India only around 4%.

4. The Macro and the Micro
Approach
• The other view consists in asking which of the
projects is to be the most preferred, which less
preferred, in other words ranking projects by
comparing their respective cost benefit streams.
• This is the micro view, while the other view is the
macro view.
• The micro view corresponds to project appraisal.
• The macro view corresponds to project financing.

5. The Project Finance Question
• It would be insufficient to answer the preceding
questions by saying that the projects in Rest of the
World are better than the projects in Africa or that
projects in South Africa are better than the
projects in rest of Africa.
• In this context, project appraisal degenerates into a
non-issue. In fact, what one is saying is that no
matter how superior the projects in terms of the
output or impacts in Africa, the chance of their
attracting finance is roughly 1/10th of the project in
Latin America.

6. Project Finance: the Macro View
• The foregoing questions probe the wider realm of
economic environment and policy.
• The issues they raise are as to how should one
manage the economy so that one attracts higher
levels of inflows into the projects in that economy.
– But projects are nothing but packets of investments into
identified activities with specific technological
outcomes.
• Hence, the issue boils down to how to raise
investments in the economy.

7. Project Financing: Four Phases
• Pre-World War II
– The case of Indian Railways but Taj Mahal or pyramids
would be a similar story.
• 1950 to 1980
– Public Sector as the preferred vehicle
– Multilateral Development Banks
• 1980 to 2000
– Bringing Private Sector back in
• 2000 onwards
– Public Private Partnerships
• Our focus on post world war II years or the post colonial era

8. Savings and Investments
Much of the post war public sector led investment growth
owes itself to the propositions embedded in the Keynesian
macroeconomics. The world before Keynes, believed in
Say’s Law which says that supply creates its own demand.
• In this system, there is no place for general overproduction
or unemployment. However, unemployment in specific
sectors is possible. Further, wage rate rigidities may pose
problems in adjustment.
• The Great Depression (1929-33) when stock markets
crashed, the income levels fell by half and unemployment
rose to unprecedented levels could not be explained by
Say’s Law.

9. The Macroeconomics of
Depression
• Keynes put forth the argument that if realized
investment in a period is more than the planned,
then investment is cut back.
• This leads to lower aggregate demand for the
output, leading to unemployment on the one hand
and excess capacity on the other. Downward wage
flexibility does not help, because then the
aggregate demand becomes even lower.
• Increasing money supply does not help, because
the additional money is simply held as liquidity to
avoid capital losses in the event of rise in interest
rates.

10. Dealing with Depression: Fiscal
Policy
• Fiscal Policy is about Government spending and
taxes
– Taxes reduce output
– Government spending boosts output
• Entail Keynesian Policy prescription- ‘dig holes
and fill them up’ because that boosts aggregate
demand.
• It is immaterial how the Government finances its
expenditure.

11. Fiscal Policy for Developing
Economies
• In the post world war scenario, with the colonies acquiring
independence, development became the key agenda of
national governments.
• In a developing country, savings are low due to low
incomes. Low savings mean low investments and hence,
lower income in the future. This is the vicious circle.
• One way out of the vicious circle is that Government may
itself increase investments either through higher taxes or
through higher debt.
• This led to the public sector acquiring the commanding
heights and adoption of import substituting model of
growth. (Why import substituting?)

12. Why Fiscal Policy may not work
in general
• In cases where there is no excess capacity, the
increase in Government expenditure would induce
inflationary pressure.
• With inflation, the domestic currency may be
expected to lose value.
• In inflationary situations, the nominal rate of
interest may also rise, which would scare
investments.
• In general, increase in fiscal deficits would be self
defeating either through explosion in interest
payment or through crowding out.

13. The Swing from Public to Private
• Eventually, the public sector led model
began to wear due to resurgence of belief in
markets and open economies in the wake
of the following events-
– Oil Shock
– Stagflation
– Inefficiencies in the public sector
– Growth record of open economies turned out to
be superior to those with closed economies.

14. Public Private Partnership
• The romance with privatization lasted even less
owing perhaps to the following-
– The private sector did not move in as big a way as
expected following privatization initiatives.
– A series of corporate scandals shook public confidence
in corporate governance.
– Nature of risks underlying projects turned out to be
more difficult to deal with e.g. tariff fixation,
regulation, etc.
• The model now is the Public Private Partnership
Model

15. Increasing investments in open
economy framework
• To finance investments, either one mobilizes
domestic savings or attracts savings from abroad.
• Mobilizing domestic savings means mobilizing
savings of households, internal accruals of
companies and savings by the Government.
• It is only the special case of unemployment and
idle resources, and not the general case, where it
is possible for Government to boost income by
raising expenditure.

16. Attracting Investments: The new
macro policy framework
• Private sector investments are based on
expectations of future flows.
• Future flows in developing economies should be
more robust than in developed countries. (owing
to the marginal return principle)
• The three-fold formula for attracting investments
is:
– Open economy
– Fiscal Prudence
– Good institutions to keep transaction costs low

17. Institutional Framework for
Project Finance
• Two broad categories of finance- debt and equity
• Both debt and equity can be from domestic or
foreign sources.
• Domestic sources often inadequate and less
developed and virtually non-existent for long
tenors in developing economies.
• This entails increased emphasis on involvement of
international banks, supplier’s credit, multilateral
agencies, ECAs and equity funds.

18. Conceptual Underpinnings of
Project Finance
• Project Finance is closely associated with
provision of public goods e.g. roads, health.
• Public Goods are defined as those goods where
there is non-rivalry and non-excludability.
• Non-rivalry means that consumption of the good
by one person does not affect the consumption by
others. e.g. parks, roads etc.
• Non-excludability refers to the inability to deprive
anyone from consumption of the goods. those
which when left to market forces are not produced
in sufficient quantity.

19. Why Markets Fail
• Market Power
• Incomplete Information
• Externalities
• Public Goods

20. Market
In case of there being some monopoly industries,
the monopoly industries will produce an output
which is smaller than that of a like competitive
industry, therefore, given total employment less
resources would go in monopoly and more in
competitive industry that what would be the case
if all industries were competitive. However, if all
industries are monopolies then this result does not
hold, which is what theory of second best is all
about. Some competition may conceivably be
worse than none and monopolies in all industries
may conceivably be better than monopoly in some
industries.

21. Incomplete Information: Asymmetric
Information: The case of ‘Lemons’
The issue: Why does a six month car old car sells
for so much less than a new one?
Lemon is a used car constantly subject to
mechanical troubles.Some small proportion of
used cars are lemons. The seller of used cars
knows which car, but the buyer does not. This is
asymmetry in information.
First inference: Good quality cars are driven out of
the market.
Second inference: Discounting of the used car
price for the reason that some of them are lemons.

22. Externalities
Externalities arise where there is a
difference between private and social costs
or private and social benefits.
e.g.. A steel plant dumping its waste in the
river which affects the catch of the
fisherman.

23. Public Goods
• The consumption of Public Goods is
characterized by-
– Non-rivalry (no additional cost for use by an
additional consumer e.g. highway)
– Non-exclusion (not possible to exclude anyone from
consumption e.g. Law and order)
The consequence is free rider problem, whereby one
understates the value of the good so that one can
enjoy the benefit without having to pay for it.

24. PPP Framework for Project
Financing
• Identification of Value for Money
proposition by a public agency- The public
good character
• Institutional Structure for PPP- Special Law
for PPP – South Africa vs. India
• Competitive bidding and transparency
• Financing Options

25. Models of Long Term Finance
• Two broad models
– Market Based- Anglo American
– Bank Based- Japan
• Convergence is being noticed as Financial Service
Providers embrace the Universal Banking Model.
• Developing Countries did not have deep capital
markets. The policy, therefore, was to have a
directed regime of ‘priority’ sector based
financing by banks and long term project
financing by development financial institutions
(DFIs).

26. External Sources of Finance
AS % of Total Sources of Funds
1985-86 to 1991-92 to 1992-93 to 1997-98 to
1990-91 2000-01 1996-97 2000-01
Equity 7 16.1 20.5 12.8
Borrowing 36.2 32 33.2 28.3
Debentrs 10.3 6.2 5.2 6.1
Banks 12.7 10 10.7 9.4
FIs 8.4 9.5 8.3 9.8
Others 22.5 15.9 14.8 15.3

27. Maturity Profile of Loans (2003-04)
Percent
In years Public Old Pvt. New Pvt. Foreign
Sector Banks Banks Banks
Up to 1 40 41 35 57
1-3 33 36 31 16
3-5 12 10 13 8
Over 5 15 13 21 19