First published 2007
by Taylor & Francis
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
Simultaneously published in the USA and Canada
by Taylor & Francis
270 Madison Ave, New York, NY 10016, USA
Taylor & Francis is an imprint of the Taylor & Francis Group, an
informa business
© 2007 Willie Tan
All rights reserved. No part of this book may be reprinted or
reproduced or utilised in any form or by any electronic, mechanical, or
other means, now known or hereafter invented, including photocopying
and recording, or in any information storage or retrieval system,
without permission in writing from the publishers.
The publisher makes no representation, express or implied, with regard
to the accuracy of the information contained in this book and cannot
accept any legal responsibility or liability for any efforts or omissions
that may be made.
Publisher’s Note
This book has been prepared from camera-ready copy provided by the
author.
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging in Publication Data
Tan, Willie.
Principles of project and infrastructure finance / Willie Tan.
p. cm.
Includes bibliographical references and index.
ISBN 978-0-415-41576-7 (hardback : alk. paper) --
ISBN 978-0-415-41577-4 (pbk. : alk. paper)
1. Capital investments. 2. Corporations--Finance. 3. Infrastructure
(Economics)--Finance. 4. Risk management. I. Title.
HG4028.C4T36 2007
658.15
5--dc22
2006039620
ISBN10: 0–415–41576–4 Hardback
ISBN10: 0–415–41577–2 Paperback
ISBN10: 0–203–96250–8 ebook
ISBN13: 978–0–415–41576–7 Hardback
ISBN13: 978–0–415–41577–4 Paperback
ISBN13: 978–0–203–96250–3 ebook

CONTENTS
Abbreviations and notations x
Preface xi
1 Introduction 1
1.1 Purpose of this book 1
1.2 What is project finance? 2
1.3 History of project finance 3
1.4 Approaches to project finance 5
1.5 Importance of project finance 6
1.6 Organization of this book 6
2 Time Value of Money 8
2.1 Future value of present sum 8
2.2 Present value of future sum 9
2.3 Present value of income stream 9
2.4 Gordon’s formula 11
2.5 Real and nominal rates of interest 13
2.6 Components of interest rates 14
2.7 Determinants of interest rates 15
2.8 Term structure of interest rates 18
2.9 Deficit financing and interest rates 19
2.10 Credit rationing 20
2.11 Continuous time discounting 22
3 Organizations and Projects 26
3.1 Functions of management 26
3.2 Management competencies 27
3.3 Corporate strategy 27
3.4 Business strategy 31
3.5 Functional strategy 35
3.6 Strategic project office 35
3.7 Project management maturity 36
3.8 Public organizations 37
4 Corporate Finance I 42
4.1 The balance sheet 42
4.2 Analyses of balance sheets 44
4.3 Financial ratios 46
4.4 Off-balance sheet items 46
4.5 The income statement 48
4.6 Operating ratios 49
4.7 Profitability ratios 50
4.8 Free cash flow 50
4.9 Market ratios 50

5 Corporate Finance II 55
5.1 Sources of funds 55
5.2 Preferred stock 56
5.3 Common stock 57
5.4 New issues 66
5.5 Bonds 67
5.6 Bank loans 69
5.7 Pseudo-equity 70
5.8 Weighted average cost of capital 70
5.9 Optimal capital structure 71
6 Project Development 75
6.1 Owner’s need 75
6.2 Request for Proposal 76
6.3 General description of facility 76
6.4 Requirements and specifications 78
6.5 Budget 78
6.6 Financial feasibility 79
6.7 Project authorization 86
6.8 Procurement method 87
6.9 Design development 91
6.10 Detailed estimates 93
6.11 Tender documents 93
6.12 Contractor selection 94
6.13 Construction 96
6.14 Project close-out 99
7 Social Projects 102
7.1 Private and social considerations 102
7.2 Valuation of social benefit 104
7.3 Valuation of social cost 105
7.4 Real and pecuniary effects 107
7.5 Incremental outputs 107
7.6 Price distortions 109
7.7 Wage distortions 111
7.8 Shadow prices 111
7.9 Externalities and missing markets 112
7.10 Option value 116
7.11 Distributional issues 116
7.12 Project sustainability 117
7.13 Multiplier effects and development 117
7.14 Choice of hurdle rate 118
7.15 Income effects 119
7.16 Case study 120

8 Characteristics of Project Finance 124
8.1 The structure of project finance 124
8.2 Corporate finance 125
8.3 Conventional public procurement structure 126
8.4 Public-private partnerships (PPP) 126
8.5 Stakeholders 128
8.6 Sponsors 128
8.7 Equity investors 128
8.8 Host government 129
8.9 Lenders 131
8.10 Suppliers 132
8.11 Contractors and consultants 132
8.12 Operator 133
8.13 Off-take purchaser 133
8.14 Other stakeholders 134
8.15 Stakeholder politics 134
8.16 Stakeholder management 136
9 Risk Management Framework 138
9.1 Risk and uncertainty 138
9.2 Probability 139
9.3 Discrete and continuous variables 142
9.4 Moments 143
9.5 Risk exposure 145
9.6 Scope of risk management 146
9.7 Objects of risk management 146
9.8 Risk management contexts 150
9.9 Objectives of risk management 151
9.10 Methods of risk management 152
10 Risk, Insurance, and Bonds 157
10.1 Insurable and uninsurable risks 157
10.2 Mechanisms to create insurance markets 158
10.3 Structure of insurance markets 159
10.4 Degree of risk aversion 160
10.5 Premium and optimal coverage 164
10.6 Interactive effects 166
10.7 Self-insurance and self-protection 166
10.8 Practical considerations in insurance 166
10.9 Bonds 168
11 Cash Flow Risks 173
11.1 Uncertain initial cost and cash flows 173
11.2 Estimating initial cost 174
11.3 Payback period 175
11.4 Conservative estimates 175

11.6 Sensitivity analysis 176
11.7 Scenario analysis 179
11.8 Monte Carlo analysis 179
11.9 Value at risk 182
11.10 Forecasting models 183
12 Financial Risks 191
12.1 Derivatives 191
12.2 Forwards 191
12.3 Futures 191
12.4 Swaps 192
12.5 Caps and floors 194
12.6 Real options 195
12.7 The Binomial model 197
12.8 Stochastic processes 199
12.9 The Wiener process 200
12.10 The generalized Wiener process 202
12.11 Ito’s lemma 203
12.12 Determinants of exchange rates 209
13 Agreements, Contracts, and Guarantees 213
13.1 Types of agreements, guarantees, and contracts 213
13.2 Functions of contracts 213
13.3 Remedies 214
13.4 Shareholders’ Agreement 215
13.5 Implementation Agreement 216
13.6 Loan Agreement 216
13.7 Security Agreement 220
13.8 Purchase Agreement 221
13.9 Concession Agreement 222
13.10 Supply Agreement 222
13.11 Construction contract 223
13.12 Operation and maintenance contract 225
13.13 Guarantees 225
14 Case Study I: Power Projects 228
14.1 Introduction 228
14.2 Types of power plants 228
14.3 Feasibility of power plants 229
14.4 Traditional financing arrangements 231
14.5 Regulation of electricity prices 231
14.6 Independent power producers 233
14.7 Risks in power projects 234
14.8 Market pricing 236

15 Case Study II: Airport Projects 239
15.1 Introduction 239
15.2 Monopoly of airline services 239
15.3 Deregulation of airline services 240
15.4 Privatization of airports 241
15.5 Hub and spoke networks 241
15.6 Feasibility of airports 242
15.7 Air cargo and other services 243
15.8 Annual benefits and costs 243
15.9 Politics of airport projects 244
15.10 Project finance structure 245
16 Case Study III: Office Projects 249
16.1 Introduction 249
16.2 Dynamics of office markets 249
16.3 Feasibility of office projects 254
16.4 Project finance structure 255
16.5 Risk management 256
16.6 The case of Suntec City 257
17 Case Study IV: Chemical Storage Projects 262
17.1 Introduction 262
17.2 Organization of petrochemical complex 262
17.3 Shanghai Chemical Industrial Park 263
17.4 Vopak Shanghai Logistics Company 265
17.5 Project finance structure 265
17.6 Land option 266
17.7 Risk management 267
Appendix: Cumulative standard normal distribution 269
References 271
Index 278

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