548 Corporate Finance
in a project is the completion risk which refers to the actual costs of constructing the project exceeding the
estimated costs, the completion date may be subject to unexpectedly long delays; the facility may be incapable
of producing the output in the right quantity and quality as originally planned. Project level risks are usually
mitigated through contractual agreements. Sponsors minimize revenue exposure to changing market conditions
through sales or revenue contracts. Exhibit 27.3 presents a summary of the risks, participants and mechanisms
(to cover risk). Risks can vary according to the nature of the project. For instance, market demand and
interconnectivity charges are sources of risk in case of telecommunication projects whereas low asset coverage
and low toll collections are the risk factors in case of road projects.
Agency Cost of Debt
An agency relationship is a contract under which one or more persons (the principal/s) engage another per-
son (the agent) to perform some service on their behalf, which involves delegating some decision making
authority to the agent. If both are utility maximizers, then there is good reason to believe that the agent will
maximize his utility. So the principal may have to incur monitoring costs to check his behavior and limit
divergence. The principal may suffer reduction in welfare due to divergence of interest. Agency cost is the
sum of monitoring costs and residual loss. Agency cost arises whenever there is a cooperative effort even
when there is no agency relationship. Agency cost can arise due to conflict of interests between shareholders
and managers, shareholders and bondholders. Bondholders suffer opportunity wealth loss due to a firm’s
investment, financing and dividend decisions. If the firm sells bonds, and the bonds are priced assuming that
no additional debt will be issued, the bondholders’ claim gets diluted if the firm issues additional debt of the
same or higher priority. Due to claim dilution, bondholders suffer capital loss. There is another form of
agency cost. A company suffering losses may be tempted to take on business gambles, the gains from which
largely go to shareholders, whereas if they fail shareholders have little to lose and it is the lenders who suffer.
It’s a heads-I-win, tails-you-lose situation. Smart bondholders recognize the incentive faced by shareholders
and make estimates of the behavior of shareholders. The price bondholders’ pay for the issue will be lower
to reflect the possibility of subsequent wealth transfers to stockholders. Bondholders try to protect themselves
with restrictive loan covenants. The loan covenants may lead to reduced efficiency and lower firm value.
Since the nature and boundaries of the project in the case of project finance are clear, lenders are less
exposed to agency cost. This may result in lower interest cost and higher firm value.
Exhibit 27.2 Risk sharing among project participants
Project phase/risk Participant
Developmental phase
- Technology risk Sponsors
- Credit risk Banks, developers, sponsors
- Bid risk Sponsors, financial advisors
Construction phase - Completion risk Contractors, sponsors, suppliers
- Cost over-run risk Sponsors, sub-contractors
- Performance risk Sponsors
- Political risk Sponsors
Operating phase - Performance risk O&M contractor
- Cost over-run risk Sponsors
- Liability risk Government, insurance companies
- Offtake risk Sponsors, consumers
Source: Biedelman, Carl R et al. (1990).