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Project Finance, Corporate Finance, and Structured Finance

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What are the differences between Project Finance, Corporate Finance, & Structured Finance? Please provide examples.

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The globalization of the world economies and financial markets, as well as the various regional crises over the past few years has caused the capital markets debt investors and bank loan markets to characterize actual and prospective debt investments into corporate, sovereign, and structured finance. The primary objective of this report is to provide a basic understanding of the segmentation of the various debt markets into three broad categories, corporate finance, project finance, and structured finance.

Corporate Finance
Every decision made in business has financial implications and any decision that involves the use of money is a corporate financial decision. In a very broad sense, everything that a business does fits under the umbrella of corporate finance. Corporate finance deals with the financial decisions that a corporation makes in its day to day operations. It focuses on using the capital the corporation currently has to make more money while simultaneously minimizing risks of certain decisions. The ultimate goal is to increase wealth of the corporation's shareholders.

The core corporate finance principles can be stated as follows:
? The Investment Principle: Invest in assets and projects that yield a greater return than the minimum acceptable hurdle rate.
? The Financing principle: Choose a financing mix (debt and equity) that maximizes the value of the investments made and match the financing to the nature of the assets being financed.
? The Dividend Principle: If there are not enough investments that earn the hurdle rate, return the cash to the owners of the business.

The objective in conventional corporate financial theory when making decisions is to maximize the value of the business or firm. Mergers and acquisitions are another part of corporate finance. Companies often have financial reasons for combining with another company. Ultimately all mergers and acquisitions are to affect the corporation's bottom line. When a company is merged or acquired it's usually done at market value. The "acquiring" firm has the hope that the result of the merger or acquisition will exceed the premium of the purchase.

Example of recent M & A deal:
"The largest-ever M&A transaction in the banking industry was completed in 2007. ABN AMRO's acquisition by a consortium of leading European banks was the largest-ever acquisition of a US pharmaceutical company by a non-US acquirer (AstraZeneca's acquisition of Medimmune), the largest-ever equity offering by an Indian issuer (ICICI) and the second-largest IPO ever by a Latin American issuer (BM&F)."
(Source: http://www.dpw.com/practice/corporate.htm)

Project Finance
"Project financing techniques date back to at least 1299 A.D. when the English Crown financed the exploration and the development of the Devon silver mines by repaying the Florentine merchant bank, Frescobaldi, with output from the mines." (John W. Kensinger and John D. Martin. "Project Finance: Raising Money the Old Fashioned Way, in Donald H. Chew, Jr., ed. 1993, the New Corporate Finance: Where Money Meets Practice. New York, McGraw-Hill, p. 326) .In this case the Italian bankers had a one year lease and mining concession which meant that they were entitled to as much silver as they could mine during the year.

The purpose for Project Finance is to invest in a single purpose capital asset, usually a long-term illiquid asset. In contrast to a company which may be investing in many projects simultaneously, a project financed company invests only in the particular project for which it is created. The project company is dissolved once the project gets completed.

Project Finance involves creating a legally independent project company to invest in the project. The assets and liabilities of the project company and do not appear on the sponsors' balance sheet. As a result, the project company does not have access to internally-generated cash flows of the sponsoring firm. Similarly, the sponsoring firm does not have access to the cash flows of the project company. In contrast, in Corporate Finance, the same investment is financed as part of the company's existing balance sheet.

In Project Finance, the investment is financed with non-recourse debt. Since the project company is a standalone legally independent company; the debt is structured without recourse to the sponsors. As a result, all the interest and loan repayments come from the cash flows generated from the project. This is in contrast to Corporate Finance where the lenders can rely on the cash flows and assets of the sponsor company apart from those of the project itself. The chart that follows compares specific dimensions of Corporate and Project Finance:

Corporate Finance Project Finance
Financing Vehicle Multi-purpose organization Single purpose entity
Type of Capital Permanent-an indefinite time horizon for equity Finite time horizon matches life of project
Dividend policy and reinvestment decisions Corporate management makes decisions autonomous from investors and creditors Fixed dividend policy; immediate payout; no reinvestment allowed
Capital investment decisions Opaque to creditors Highly transparent to creditors
Financial structures Easily duplicated; common forms Highly tailored structures which cannot generally be re-used.
Transaction costs for financing Low costs due to competition from providers, routine mechanisms and short turnaround time Relatively higher costs due to documentation and longer gestation period
Size of financings Flexible Might require critical mass to cover high transaction costs
Basis for credit evaluation Overall financial health of corporate entity; focus on balance sheet and cash flow Technical and economic feasibility; focus on project's assets, cash flow and contractual arrangements
Cost of capital Relatively lower Relatively higher
Investor/lender base Typically broader participation; deep secondary markets Typically smaller group; limited secondary markets

There is no singular definition of project finance. Larry Wynant defined project finance in a Harvard Business Review article as "a financing of a major independent capital investment that the sponsoring company has segregated from its assets and general purpose obligations." (Larry Wynant. Essential elements of project financing, Harvard Business Review. May-June 1980, p. 166.)

Not every project financing transaction will have every characteristic, but the following provides a preliminary list of common features of project finance transactions:
? Capital -intensive: Project financings tend to be large scale projects that require a great deal of debt and equity capital.
? Highly leveraged: These transactions tend to be highly leveraged with debt accounting for a significant amount of the capital.
? Long term: The tenor for project financings is ...

Solution Summary

The solution compares and contrasts Project Finance, Corporate Finance, and Structured Finance and provides examples.

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Discussion 1
• Assume that you recently received your MBA and now work as an assistant to the CFO of a large corporation. Your boss has asked you to prepare a financial forecast for the coming year. Address the following questions:
• How would you set up the model to be presented to the executives? How many scenarios would you choose? What other information would you provide? What would you not include and why?
• What are the pros and cons of being able to examine the results of changing dividend policy and capital structure policy?
• What are the values of financial forecasting? What is your opinion of the most important points to keep in mind when creating financial forecasts?

Discussion 2
• Why is the NPV method for budgeting accepted as the most valuable budgeting tool? If you were not allowed to use NPV for a budget you were developing, what other method(s) would you use? Explain your choices.
• Project S has a cost of $10,000 and is expected to produce cash flows of $3,000 per year for 5 years. Project L costs $25,000 and is expected to generate cash flows of $7,400 per year for 5 years.
• What is the NPV, IRR, MIRR, and PI for each project, assuming a 12 percent cost of capital?
• Which project would you select, assuming they are mutually exclusive, using each ranking? Why? Which project should you actually choose? Why?
• How do simulation analysis and scenario analysis differ in the way they treat very bad and very good outcomes? What does this imply about using each technique to evaluate risk?

Discussion 3
Franco Modigliani and Merton Miller are considered the architects of capital structure theory. They had many ideas regarding capital structure and the implications of that structure on a firm's performance. Since their first article was published in 1958, many financial theorists have attempted to test the validity of existing capital theories. This assignment will allow you to take a look at some major capital structure theories and how they influence finance.
• What does the following statement mean to you? "One type of leverage affects both EBIT and EPS. The other type affects only EPS."
• What conclusions did Modigliani and Miller draw regarding the effect of capital structure on a firm's value and cost of capital, assuming no corporate taxes?
• How do their conclusions change when each introduces corporate taxes? Explain.
• If a firm's managers thought that Modigliani and Miller were exactly right, what capital structure would they choose to maximize their firm's value? Why?
• Choose two criticisms of the MM models of capital structure. Write an argument positing that those criticisms do not outweigh the benefits of those theories.

Discussion 4
• Have you ever wanted to go into business for yourself? Why or why not?
• What tradeoffs does the entrepreneur face?
• Why is entrepreneurship so important in a market economy?

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