Economic rationales to use project finance
This section summarizes learnings from theory by distilling eight reasons that could explain the use of project finance for power generation projects. These eight reasons are clustered under 3 groups namely, financial synergies with existing business, general market imperfections and consideration regarding organizational structure.
When companies consider projects such as a new power plant, synergies with their existing business often are a key concern. While operational synergies are positive, financial synergies are often negative. Following are the reasons to prevent such negative synergies.
Contamination Risk
If new projects are financed through corporate finance, they become part of the risk-return prospects of the developing company. Also, poor project performance can affect the business severely. In perfect markets, companies should not be concerned about idiosyncratic bankruptcy risk as portfolios are diversified at the shareholder level. Realizing the project in a separate entity via project finance can preserve the existing business from contamination and thereby reduce financing cost for the core firm.
Debt Overhang
Project finance is an even more effective instrument to finance such projects as it decouples the project completely from the sponsor's balance sheet. Following this argument, project finance not only allows a sponsor to realize projects that are otherwise unviable, but also potentially allows that sponsor to choose a higher debt ratio for the project than feasible under corporate finance, creating value through higher tax shields.
Securitization
Ways in which project finance can help to address asymmetric information and agency costs;
Information asymmetry b/w sponsor & lenders
Project finance is considered as a tool that reduces asymmetries by allowing lenders to better distingu...
