The Pros And Cons Of Project Finance

In addition, one of the principal disadvantages of project finance is that high set-up costs usually associated with establishing a project finance structure can usually be justified for large projects, usually valued at over US$20 million (Ochieng et al. 2013). Moreover, the cost of debt is typically higher in project financing than conventional financing due to the indirect nature of the credit support. The credit support is provided through contractual commitments rather than through a direct promise to pay. The lenders typically will have concerns about the failure of contractual commitments to provide an uninterrupted flow of debt service. Therefore, the lenders require a yield premium to compensate for the risk (Finnerty 2013). Furthermore,

However, industrial projects are complex affairs and are a mix of personal, technological, social, and commercial aspects. This mix can create uncertainties and risks in all areas. In fact, any aspect of a project, where we do not possess perfect knowledge, is a source of potential risk (Webb 2003). According to Gatti (2013), risk is a crucial factor in project finance as it is responsible for unexpected changes in the ability of the project to repay costs, debt service, and dividends to shareholders. He claims that cash flows can be affected by risk, which can create a cash shortfall if it has not been anticipated and properly hedged. When cash is insufficient to pay creditors, the project can technically be in

Fight (2006) points out that there are three main risk periods in a project financing: engineering and construction, startup and operation. He claims that the risk is greatest in the engineering and construction phase as this stage include risks such as the sponsor risk (equity commitment and corporate strength and experience), completion risks, cost overruns and completion delays. At the start-up phase, the banks need to be convinced that the project will operate at the costs and as per specifications agreed in the beginning. Finally, during the operational phase, legal, performance, and country risks could occur. The following figure shows how risks increase throughout the phases of project finance: Figure 3.1: Risk phases and project costs (Fight 2006)

Similarly, Gatti (2013) presents various risks involved in different phases of project financing and also provides some useful methods for risk allocation which is shown in the figure below. He further emphasizes that the risks that are common to both pre- and post-completion are hedged by the exclusive use of either insurance or derivative contracts. Figure 3.2: Classification of risks and strategies for their allocation (hedging) (Gatti