Custom «Project Finance» Essay Paper

What is project finance? What are some of its salient characteristics? Discuss the benefits of project finance?

Project finance is a financing mechanism that organizations use for the realization of large-scale projects; it is widely used in developing countries and developed countries. In proposing a definition for project finance, it can be said that “at its core, project finance is a method of financing where the lender accepts future revenues from a project as a guarantee on a loan” (Slivker, 2011). In other words, it is a form of financing under which lenders release funds trusting that at a future time those funds will multiply, generate revenue, and guarantee repayment. Project finance has a set of characteristics that set it apart from other (more traditional) forms of financing. For example, project financing is founded on a project’s expected cash flow (as opposed to the sponsoring company’s balance sheet). This means that the project is analyzed, it is evaluated, based on its own strengths, weaknesses, and overall appeal; it is treated as a separate company (Pernice, 2005). As well, this type of financing has a high ratio of debt, meaning that lenders have limited abilities to collect on their funds (in case of default) as all payments of debt and equity are made exclusively from the cash flow that the project generates. Essentially, what characterizes this type of financing is that it is done exclusively through debt; companies can indulge in realizing massive projects without having to use its own assets and without having to rely on the strength of their balance sheets to secure loans. Finally, in discussing project finance’s benefits, it is worth noting that it “allows countries to build the infrastructure necessary to increase growth” (Slivker, 2011) with minimum risks (as the project pays for itself). Furthermore, project financing secures funds for projects based on the projects’ own merits; it matters not if the sponsors have strong balance sheets, but simply that the project exhibits high returns.

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EVA has become a fairly popular static to measure if a project(s) really adds value to the firm. Discuss EVA. Why is it considered a better technique than measures already being used, such as typical market measures including scoreboard. How is it used for evaluating a manager? What are some of the problems with EVA?

Economic Value Added (EVA) is an integral measure of an organization’s operating performance; “EVA measures the change in financial worth of an enterprise from one year to the next” (USPS, 2001). EVA includes the cost of the capital used to generate income (it is computed by subtracting cost of capital from net operating income), which makes it more comprehensive than other methods, including net income (USPS, 2001). In recent years, EVA has become quite popular within organizations; this owes to three advantages that it has over other measures already being used. First of all, it is advantageous that the “EVA links the use of capital with unit financial performance and provides a business focus for unit management” (USPS, 2001). Second, it constitutes an incentive for employees to minimize expenses and capital in production processes; the unit financial performance approach motivates employees to strive for higher levels of efficiency. Third, “EVA empowers employees who are accountable for producing maximum results and minimizing resources used” (USPS, 2001). A fourth benefit that can be mentioned is that EVA allows for comparative analysis; management can evaluate employee and organizational performance over time. Management greatly benefits from EVA insomuch as it allows for a more complete analysis of the company’s performance, which in turn allows for more efficient resource allocation. Furthermore, EVA can be used to evaluate managers; it allows for performance monitoring and enhances efficiency (through an incentives scheme). However, in order for EVA to be used in manager evaluation, it is important that organizational objectives, evaluation criteria, and incentives schemes be defined in detail. EVA, then, not only evaluates managers, but incentives to be more efficient as well. Finally, it is important to keep in mind that there is problem in using EVA. EVA is a narrow method; it is too specific and because of this will only work properly when it is tailored to the organization’s specific culture, structure, and market position.

In one of our case presentations, the presenters discussed contingent payment or a callback feature. What is it and how does it work? You may use the case to illustrate the feature (if you are too busy to look for other examples).

Contingent payment is that which is only made after a given condition has been met in full. In other words, it is a form of payment that attempts to minimize uncertainties in order to protect an organization’s resources (especially in cases where the risk of incremental costs surfaces). In essence, contingent payment works on the basis of actual costs (as opposed to projected costs). Organizations will release payments in the degree that those payments are required (given that specific products of services have been received, for example); organizations will refrain from indulging in long term commitments on their financial resources. The textbook example of this form of payment is the stock option. When real prices are higher than option prices, holders will make use of their options to make a profit. Conversely, when real prices are lower than option prices, holders will not make use of their options (given that doing so would constitute a loss).

In one of our case presentation, the group discussed disagreement between EU and our DOJ concerning a merger between two companies. Discuss what the “bone of contention” was and how it was resolved.

Throughout the case presentation, there were various points in which the opinions of the European Union (EU) and the U.S. Department of Justice (DOJ). The case focused on a 42 billion USD proposal that General Electrics (GE) made to purchase aerospace manufacturer Honeywell. Specifically, the diverging opinions between the EU and the DOJ had to do with the monopolistic competition implications that such a merger would have in the aerospace industry. Moved by the belief that the merger served to strengthen competition in the sector, the DOJ approved the merger as it believes that it will lead to decreased prices (for the benefit of customers). Conversely, the EU rejected the merger as it believed that it would consolidate GE as a monopolistic competitor in the industry. Evidently, the DOJ was moved by the desire to benefit market customers; the EU was moved by the desire to protect the industry’s competitors. the “bone of contention” between both entities was ultimately resolved by the conformation of a joint team that was tasked with evaluating the merger proposition and determine if it will generate deadweight loss or not.

Define corporate governance. How does the corporate governance in this country differ from other countries like Japan and Germany? What criticism can you levy against the corporate governance of these other countries? In your opinion, has the Sarbanes-Oxley Act reformed corporate governance?

Corporate governance can be defined as the set of processes, policies, institutions, customs, and legal regulations that affect the way in which a managerial team directs and controls an organization. Furthermore, it is important to point out that “good corporate governance practices instill in companies the essential vision, processes, and structures to make decisions that ensure longer-term sustainability” (U.N. Global Compact and the International Finance Corporation). In discussing corporate governance, it is also important to mention that corporate governance varies among countries; in Japan and Germany, for example, corporate governance is exercised differently than in the United States. First, in Japan corporate governance models are heavily influenced by the monitoring of banks and large shareholders. In Japan, contrary to what happens in the United States, banks have significant corporate equities, which empower them within organizations (allowing them to have a say in the way in which managers make use of the organizations’ resources). Second, Germany’s corporate governance models are characterized by the fact that insider shareholders have significant stakes in organizations’ ownership. Here again one identifies a difference between the German and the American models; in the United States insider shareholders have minimum stakes within organizations. Ultimately, these models are advantageous insomuch as they allow shareholders to protect their investments (something that does not happen in the United States); in the United States managers have absolute autonomy, which allows for more maneuverability (and may enhance efficiency, growth, and development). Finally, in discussing the Sarbanes–Oxley Act (2002), it must be said that it has constituted a positive reform in terms of protecting stakeholders’ interests.

What are the primary motives for corporate restructuring? Discuss and distinguish equity carve-out, spin-offs and divestiture.

Corporate restructuring, which consists on redesigning one or various aspects of an organization’s structure, is primarily motivated by the desire to enhance company/shareholder value. When companies indulge in corporate restructuring they do it because they wish to become more competitive. Generally, there are three ways in which organizations can go about restructuring. First, equity carve-out occurs when large organizations let go minority shares in subsidiaries; this is done so that the organization can focus all of its resources and efforts on its primary productive processes. Second, spin-offs comprehend a process through which an organization’s section and/or department is split from the main structure and stands alone as an independent entity. Spin-offs are generally realized with sections and/or departments that are underperforming in terms of generating profit for shareholders. Third, divestitures comprehend a process through which an organization partially sells its assets to another company; divestitures are realized on assets that are underperforming in terms of generating profit. In all three cases, it is clear that the fundamental reason for engaging in corporate restructuring is the same, minimizing costs in order to focus on core business activities (and maximize profits).

What is mezzanine financing? What are its characteristics? When is such financing used and what type of firm is most apt to use such financing?

Basically defined, “mezzanine financing is a hybrid between debt and equity” (Inc, 2012); it constitutes a loan that is subjected to levels of senior debt and secured junior debt. In discussing the characteristics of mezzanine financing (other than its subordination to senior and junior debt, which was already mentioned), it must be said that given its high risks (for the lender), it is highly expensive for organizations to procure. Second, this form of financing provisions that if the organization should default on its loan payments, the lender has the option of converting the loan’s securities into equity at a given price per share, which means that it is also risky for organizations (as shareholders stand to lose ownership if investments go sour). Third, despite its evident risks, mezzanine finance offers organizations the opportunity to invest in existing projects in order to expand and enhance them; the same applies for organizations in general. Fourth, given its elevated costs (particularly in terms of servicing the debt), mezzanine financing is usually not an option for large, financially strong organizations, but rather for smaller, weaker companies (as they cannot afford to procure other forms of financing). Fifth, it is worth noting that it also allows for tax deductibility of interest (as it can be internalized as operating expense).

Recently, private equity has been mentioned quite frequently in the popular press as well as in the presentation of a case. Discuss private equity -what it does its role in our financial system and its importance.

Before discussing private equity, it is important to define it. This being said, private equity can be defined as “capital invested in the direct ownership of businesses that are not traded on public stock exchanges” (Phillips, Hager, & North Investment Management Ltd., 2008). There are three structures that private equity can be found in: limited partnership; fund of funds; direct investment. In all of its three structures, private equity seeks to procure investment funds for private companies (they may also be used to buyout public companies and privatize them). When not used to buyout out companies, private equity can be used to fund research and development projects, infrastructure projects, or simply to expand working capital (and output) within a privately owned company. In essence, private equity seeks to privatize and strengthen companies so as to make them more competitive and profitable. In terms of importance, it can be said that private equity is important simply because it enhances company performance, thus generating strong and sustainable growth. In 2006, for example, the private equity industry showed remarkable growth and strength. “The average enterprise value (EV) of the businesses studied in the US grew from US$1.2bn when acquired, to US$2.2bn at exit (+83%). In Europe, the average value grew from US$800m to US$1.5bn at exit (+81%)” (Ernst & Young, 2007).