Companies are increasingly using project finance to fund large-scale capital expenditures. The decision to use project finance involves an explicit choice regarding both organizational form and financial structure. With project finance, sponsoring firms create legally distinct entities to develop, manage and finance the project. Borrowing occurs on a limited or non-recourse basis and despite this, projects are highly leveraged entities. Debt to total capitalization ratios average 60-70%. The issue explored in the write up below is why firms use project finance instead of traditional, on-balance sheet corporate finance. The notion/argument that in the right settings, project finance allows firms to minimize the net costs associated with market imperfections such as taxes, transaction costs etc is explored below. At the same time, project finance allows firms to manage risks more effectively and more efficiently. These factors make project finance a lower-cost alternative to conventional corporate finance. Costs and benefits of using project finance, major risks and mitigation of these risks as well as evaluation of debt alternatives are all explored below using the Petrozuata deal as an example. PDVSA should ultimately finance the development of the Orinoco Basin using project finance and a detailed explanation can be found below. PROJECT FINANCE – COSTS AND BENEFITS OF USING PROJECT FINANCE Project Finance involves a corporate sponsor investing in and owning a single purpose, industrial asset through a legally independent entity financed with non-recourse debt. The decision to finance this deal on a project basis was actually a dual decision regarding both financial and organizational structure. Instead of entering into a joint venture with Conoco, PDVSA could have build the project alone and relied on spot market transactions to sell the syncrude. However PDVSA would have needed specialized assets to extract and upgrade the syncrude which would have left it vulnerable to potential opportunistic behavior by its downstream customers. Alternatively Conoco could have decided to build the project itself since it already had the downstream refining capacity. Venezuelan law however would prevent Conoco from going it alone as it prohibits foreign ownership of domestic hydrocarbon resources. So a joint venture with a long-term off-take arrangement was created as a way to encourage investment in specialized assets, limit ex post bargaining costs and deter opportunistic behavior. Structured in this fashion, Petrozuata had all the hallmarks of project finance deals i.e. it was an operating company with a limited life (35 years), it was an economically and legally independent entity and it was funded with non-recourse debt. So Petrozuata could definitely be classified as a project. The three characteristics listed above distinguish project finance from traditional corporate finance. To explain the costs and benefits of using project finance, let’s start with M&M’s capital structure irrelevance proposition which holds that firm value should not depend on how a firm finances its investments. So whether a firm uses corporate or project finance to raise funds should be a matter of indifference to its shareholders. A lot of assumptions are baked in here for example, no taxes, no transaction costs, no costs of financial distress. Capital markets however are not perfect so in the real world, in addition to taxes, transactions costs, costs of financial distress, there are costs stemming from incentive conflicts among managers, shareholders and creditors as well as from asymmetric information between corporate insiders and outsiders. Let’s take each of these factors one by one: Project finance reduces corporate taxes – The creation of an independent entity allows projects to obtain tax benefits that are not available to their sponsors. In this case, Petrozuata will pay reduced royalty rates on oil revenue and income tax...
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