Funds Estimation in Project: Means of Financing, Types of Financing, Sources of Finance
Last updated on 26/07/2023 1 By indiafreenotesProject finance is the long-term financing of infrastructure and industrial projects based upon the projected cash flows of the project rather than the balance sheets of its sponsors. Usually, a project financing structure involves a number of equity investors, known as ‘sponsors‘, and a ‘syndicate‘ of banks or other lending institutions that provide loans to the operation. They are most commonly non-recourse loans, which are secured by the project assets and paid entirely from project cash flow, rather than from the general assets or creditworthiness of the project sponsors, a decision in part supported by financial modelling; see Project finance model. The financing is typically secured by all of the project assets, including the revenue-producing contracts. Project lenders are given a lien on all of these assets and are able to assume control of a project if the project company has difficulties complying with the loan terms.
Generally, a special purpose entity is created for each project, thereby shielding other assets owned by a project sponsor from the detrimental effects of a project failure. As a special purpose entity, the project company has no assets other than the project. Capital contribution commitments by the owners of the project company are sometimes necessary to ensure that the project is financially sound or to assure the lenders of the sponsors’ commitment. Project finance is often more complicated than alternative financing methods. Traditionally, project financing has been most commonly used in the extractive (mining), transportation, telecommunications, and power industries, as well as for sports and entertainment venues.
Risk identification and allocation is a key component of project finance. A project may be subject to a number of technical, environmental, economic and political risks, particularly in developing countries and emerging markets. Financial institutions and project sponsors may conclude that the risks inherent in project development and operation are unacceptable (unfinanceable). “Several long-term contracts such as construction, supply, off-take and concession agreements, along with a variety of joint-ownership structures are used to align incentives and deter opportunistic behaviour by any party involved in the project.” The patterns of implementation are sometimes referred to as “project delivery methods.” The financing of these projects must be distributed among multiple parties, so as to distribute the risk associated with the project while simultaneously ensuring profits for each party involved. In designing such risk-allocation mechanisms, it is more difficult to address the risks of developing countries’ infrastructure markets as their markets involve higher risks.
A project can only come together with all the necessary materials and labor, and those materials and labours cost money. Putting together a budget that keeps costs to a minimum, while maximizing the project’s quality and scope can be challenging. This is why proper cost estimation is important.
Cost estimation in project management is the process of forecasting the financial and other resources needed to complete a project within a defined scope. Cost estimation accounts for each element required for the project from materials to labour and calculates a total amount that determines a project’s budget. An initial cost estimate can determine whether an organization greenlights a project, and if the project moves forward, the estimate can be a factor in defining the project’s scope. If the cost estimation comes in too high, an organization may decide to pare down the project to fit what they can afford (it is also required to begin securing funding for the project). Once the project is in motion, the cost estimate is used to manage all of its affiliated costs in order to keep the project on budget.
Project Cost Estimation is a crucial process that involves approximating the overall expenditure of a project. The accuracy and effectiveness of cost estimation and budgeting in project management depend on the precision and comprehensiveness of the project scope, known as the scope baseline. This scope defines the project’s boundaries, constraints such as timelines, available resources, and budget limitations.
To determine the project’s costs, the risk register plays a pivotal role. It aids in calculating various cost estimates, including expenses associated with contingency plans and those incurred to mitigate risks. By analyzing potential risks and their financial impact, project managers can better plan for unforeseen events and allocate resources more effectively.
There are two key types of costs addressed by the cost estimation process:
- Direct costs: Costs associated with a single area, such as a department or the project itself. Examples of direct costs include fixed labor, materials, and equipment.
- Indirect costs: Costs incurred by the organization at large, such as utilities and quality control.
Various cost types into categories:
- Labour cost: The cost of team members working on the project, both in terms of wages and time.
- Equipment cost: The cost of resources required for the project, from physical tools to software to legal permits.
- Cost of supplies:
- Travel cost
- Training cost
- Overhead cost, etc.
Types of Financing, Sources of Finance
- Non Recourse Loan: A loan in which the lender cannot claim more than the collateral as repayment in the event that the loan is enforced.
- Full Recourse Loan: A loan in which the lender can claim more than the collateral as repayment in the event that the loan is enforced. Thus, a full recourse loan places the Sponsor’s assets at risk.
- Limited Recourse Loan: A loan in which the lender can claim more than the collateral, subject to some restrictions, as repayment in the event that the loan is enforced.
Project Financing Participants and Agreements
Additional Equity Investors: In addition to the sponsors, there frequently are additional equity investors in the project company. These additional investors may include one or more of the other project participants.
Sponsor/Developer: The sponsors or developers of a project financing is the party that organizes all of the other parties and typically controls, and makes an equity investment in, the company or other entity that owns the project. If there is more than one sponsor, the sponsors typically will form a corporation or enter into a partnership or other arrangement pursuant to which the sponsors will form a “Project company” to own the project and establish their respective rights and responsibilities regarding the project.
Construction Contractor: The construction contractor enters into a contract with the project company for the design, engineering, and construction of the project.
Operator: The project operator enters into a long-term agreement with the project company for the day-to-day operation and maintenance of the project.
Feedstock Supplier: The feedstock suppliers enter into a long-term agreement with the project company for the supply of feedstock (i.e., energy, raw materials or other resources) to the project (e.g., for a power plant, the feedstock supplier will supply fuel; for a paper mill, the feedstock supplier will supply wood pulp).
Product Off taker: The product off takers enters into a long-term agreement with the project company for the purchase of all of the energy, goods or other product produced at the project.
Lender: The lender in a project financing is a financial institution or group of financial institutions that provide a loan to the project company to develop and construct the project and that take a security interest in all of the project assets.
Techniques used to estimate project cost
To estimate project costs, various techniques can be employed, some of which include:
- Analogous Estimating: This technique relies on expert judgment and information from similar previous projects. The cost of a current project is estimated based on the cost of similar past projects, with adjustments made for any differences.
- Parametric Estimating: Past data and historical records are used to estimate costs for the current project. Mathematical models and algorithms are applied to calculate costs based on relevant parameters.
- Bottom-Up Estimating: This technique is considered the most reliable when the project scope is well-defined. Cost estimates are derived by breaking down the project into work packages or deliverables, and then estimating the cost for each resource or component.
- Three-Point Estimation: This method involves using three estimates – optimistic, pessimistic, and most likely – to calculate the expected cost, taking into account the uncertainties associated with the project.
- Reserve Analysis: Reserve analysis involves setting aside contingency reserves to account for potential cost overruns or risks that may impact the project’s budget.
- Cost of Quality: This technique considers the cost of ensuring quality throughout the project lifecycle. It involves investing in prevention, appraisal, and failure costs to maintain high-quality deliverables.
- PERT Estimating: Program Evaluation and Review Technique (PERT) utilizes a probabilistic approach to estimate project costs, incorporating uncertainty and risk factors in the estimation process.
- Vendor Bid Analysis: When external vendors are involved in the project, analyzing their bids and proposals can provide valuable insights into the estimated costs of specific project components.
Each of these techniques has its strengths and weaknesses, and the choice of method depends on factors like project complexity, data availability, and the level of accuracy required for cost estimation. By employing a combination of these techniques, project managers can arrive at more reliable cost estimates and better manage project budgets.
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