550 Corporate Finance
its efficiency. Further, if the bankruptcy costs of the sponsor are higher than that for the project company, it
is beneficial to isolate the debt in the project company.
Inside Information
Information asymmetry occurs when the management of a company has valuable information about the
earning prospects that investors do not have, may be because the managers are unwilling to disclose information
due to strategic reasons or the information is too technical and complex to be communicated. Project financing
reduces the cost of information asymmetry particularly in the case of large-scale, high-risk projects as project
finance involves a small group of investors.
Other Advantages
Project financing can provide clearer information to investors as the project is separately identifiable.
Consequently, the effect of the project’s failure on the share price of the parent company may be less. The
performance of the project’s managers can be assessed more accurately in the case of a stand-alone project.
More important, managerial incentives can be tied to the performance of the project.
TYPES OF CONTRACTS
Long-term agreements relating to purchase and sale are a characteristic of project finance. Some of the
widely used types of contracts are:
- Take-or-pay contract
- Take-if-offered contract
- Hell-or-high water contract
- Throughput agreement
- Put-or-pay contracts.
In a take-or-pay contract the purchaser is obligated to pay for the output regardless of whether the purchaser
takes delivery or not. But the purchaser has the option to take delivery. Also the purchaser is not obligated to
pay if the project is unable to deliver the output. Payments under take-or-pay contracts may be set to cover
all fixed costs or may cover only a part of the project’s capacity.
A take-if-offered contract is similar to the take-or-pay contract except that the purchaser has the obligation
to take delivery.
In a hell-or-high water contract, as the name suggests, the purchaser has the obligation to pay for the
output regardless of whether the output is delivered or not. Obviously, such a contract is in the interest of the
lenders as they get more protection.
Many oil pipeline loans involve a throughput agreement. In a throughput agreement if other companies
do not make sufficient use of the pipeline, the owners themselves should ship enough oil through it to
provide the pipeline company with the cash it needs to service the loan.
Put-or-pay contracts provide for a secure supply of project raw materials. If the supplier is unable to
provide the inputs, it agrees to indemnify the project company for excess cost incurred in securing the inputs