Tianjin Plastics

Introduction

In 1996 Pat Johnson, project finance analyst for US-based Maple energy, was faced with the hard task of deciding whether or not to build a new power plant in Tianjin, China. The setup would be a BOT (build-operate-transfer) arrangement, which would generate positive cash flows from 2000 up until 2020, after four years of construction. Maple would take a controlling stake of 49% in a joint venture that was to be formed with local partner Tianjin Plastics/Chinese Ministry of Power Industry (MOPI). Despite Maple being the largest stakeholder, they were faced with several demands of the Chinese government which would seriously impact the financial viability of the project. For instance, Chinese government attempted to keep the ROI down, refused to guarantee fulfillment and most of all, it did not allow registered capital to be repatriated. Furthermore, there was no certainty at all regarding the exchange rate of the Rmb to the US$ and there was no way of hedging. All in all, there were numerous reasons not to undertake this project, but Maple really wanted it to happen, because there was a whole new market of similar projects to be entered in China. If Maple managed to succeed in this project, it would establish a first-mover advantage for this new market, which could turn out to be very profitable. Taking everything into consideration, even though the obvious risks, it might be wise not to disregard this investment opportunity too easily…

1. Risks of the project

Construction risk

Construction is forecasted to take four years. As always, there is a risk of a delay in construction. This might be magnified by the fact that Maple, which itself is an experienced corporation with a good reputation, has to work together with less experienced partners. Moreover, construction itself is subcontracted to other firms, of which we cannot establish a track record. Any losses from a delay in construction would logically be suffered by all parties involved, relative to their equity stake in the project.

Operating risk

We think it is hard to predict the operating risk, because just as is the case with construction, operation of the plant is subcontracted to third parties. The fact that the key input factor of coal feedstock is provided for free for twenty years significantly decreases operational risk. We cannot make a solid prediction for other factors, such as the likelihood of breakdowns in internal procedures, though. Same as for the construction risk, we think that Maple, Tianjin and MOPI are all exposed to a certain operating risk.  

Currency risk

The fluctuations in exchange will affect the debt structure. In this project, Maple borrowed 90.7 million yuan RMB (from Bank of China, at a period of 12 years and interest rate of 13%), 33 million dollars (at a period of 6 years and interest rate of 6.9%) and 57 million dollars (at a period of 10years and interest rate of 7.7%) at the same time. The income of the SPV is mainly denoted in Rmb, but most of the project loan is denoted in US$, so the fluctuation in exchange rate will directly affect the debt paying ability of the project, thus increasing the exchange rate risk. Moreover, the renminbi was not freely convertible, so repatriation of profits or debt-service would have to be approved by government. The value of the renminbi itself was not very dependable either, it fluctuated quite a lot over the years. We think that foreign (from a Chinese perspective) parties are the ones who bear the currency risk, worsened by the fact that there was no way of hedging against exchange rate fluctuations. An estimation of the financial impact of exchange rate fluctuations can be found in section 2.

Credit risk

The credit risk of the project depends on many factors. If there is a major systemic breakdown, which is part of the operating risk, profits and the debt-repayment ability of the project could suffer. Part of the credit risk also lies in the currency risk. When earnings are in renminbi, but debt payments are not and the renminbi is devaluated, interest and principal repayments will be relatively expensive and the risk of default arises. There is also a risk that the Libor rate fluctuates. Some loans (the Wintel back-to-back loan for instance) may be based on the Libor plus some risk premium, so this might also have an impact on (in the case of the Wintel loan) Maple’s ability to fulfill debt obligations. In section 2, we estimate the impact of a major change in the Libor rate on the NPV of the project.

Political risk

As for the political risks, there are mainly three aspects. First, the net present value of the project and Maple Company will be enormously endangered because the return on targeted investment is influenced by the policies of Chinese government. They try to keep return on investment low, at 15% - 17%, while analysts estimated that at least 18% would be required.  

Secondly, Chinese government has a reputation of refusing to guarantee fulfillment of contracts of this type, even though MOPI is one of the parties in question. This increases the perceived risk by investors, which translates to higher costs of debt and equity.

Finally, Chinese government forbids the withdrawal of registered capital. This means Maple Company can’t return any profit and dividend to the parent company in America after the project is completed. Thus the risk cost to the shareholders is largely increased, so they will demand a higher return. We think Maple suffers most from the attitude of the Chinese government, because Maple has to make up for the risks imposed by them.

2. Maple’s expected returns: a scenario study

Introduction

In project financing a good understanding of all cash flows is essential. The investment decision is mainly based on the NPV of the free cash flows. For that reason, a good estimation of the WACC is fundamental. First, we determined the WACC for the construction phase. Because there was  no equity investment yet, the WACC in this case was equal to the cost of debt (See table below, Rd = 9,57%):