The Economics of Large Scale Infrastructure Project
Finance: An Empirical Examination of the Propensity to
Project Finance
A Thesis
Presented to the Faculty
Of
The Fletcher School of Law and Diplomacy
By RAJEEV JANARDAN SAWANT In partial fulfillment of the requirements for the
Degree of Doctor of Philosophy DECEMBER 2007
Dissertation Committee
Prof Laurent Jacque, Chair
Prof Patrick Schena

iii DEDICATION To
my parents,

Janardan and Charulata Sawant

whose passion, encouragement, dedication and
personal example made all this possible, Manisha for patience and understanding, Mehr and Manav, my personal investments in the future, and Rahul for constant and loyal support.
1.3 Project Finance loan characteristics 10

Chapter 2 : Theories of Project Finance 15
2.1 Project Finance as an asset specific investment by an initial user and a
‘redeployer’ of an asset 16
2.2 Theory of Incumbent management’s control benefits 19
2.3 Signaling Theory of Project Finance 21
2.4 Agency costs of free cash flow 23
2.5 Agency Costs of Risky Debt (Underinvestment) 25
3. Solutions to the Underinvestment Problem 29
3.1 Design of ex-ante contracts 33
3.1.1 The case of New Debt’s Strict Subordination to Existing Debt 34
3.1.2 The Case of New Debt’s Complete Seniority to Existing Debt 36
3.1.3 The Case of Project Finance 37
3.1.4 The Case of Secured Financing and Leasing 39
3.1.5 Analysis of corporate structure (Separate project finance structure or
combined corporate structure) 41
4. Project Finance Asset Characteristic – High value under default 43
4.1 The case of high project value under default and low cash flow variance 44
4.2 The Case of high asset value under default and high cash flow variance 45
4.3 The case of low asset value under default and high variance in cash flows 46
4.4 The case of low asset value in default and low variance in cash flows 47
5. Agency Costs of Opportunism or Asset Specificity (Hold-up problem) 48
5.1 Introduction 48
5.2 Solutions for the hold up problem 50
5.2.1 Vertical Integration 52
5.2.2 Long term contracts 54
5.2.3 Use of debt 58
5.3 Empirical Research on the hold up problem 62
6. Conclusion 64

5. Probit Model Results – Panel 2 114
6. Robustness Testing of the Results 116
7. Conclusion 121

Conclusion 123

Reference List………………………………………… ………………………………131

List of Sources 130 vii

List of Tables

Table I: Summary of Theoretical & Empirical Literature……………………………… 9
Table II: Analysis of Asset Risk…………………………………………………………46
Table III: List of Explanatory Variables…………………………………………… 82
Table IV: Summary of Data…………………………………………………………… 93
Table V: Statistical Properties of Corporate Vs Project Financed Investments… 93
Table VI: Summary of Statistics – Explanatory Variables………………………………94

2
and other
large capital-intensive infrastructure projects. Infrastructure Journal reports that project
finance reached $212 B in 2006, an increase of 35% over 2005
3
. Project Finance has
traditionally been a significant tool for cash strapped governments seeking to develop
vital infrastructure. In fact according to a 2005 report by the Asian Development Bank,
Japan Bank of International Cooperation and World Bank, Asia alone needs to spend $1
trillion over the next five years in road, water, communication and other infrastructure
projects to meet the rapid rise of urbanization, population growth and growing demands
of the private sector
4
. The European Union plans to spend €300B up to 2013 on
infrastructure assets
5
. An understanding of project finance and its determinants is
therefore likely to be helpful to governments, lenders, infrastructure funds and firms
investing in these assets.
Stulz and Johnson (1985), Berkovitch and Kim (1990), John and John (1991) and
Esty (2003) all contend that firms use project finance to lower “deadweight” costs
induced by stockholder-debtholder conflict (underinvestment), and by the threat of
opportunism between project sponsors and suppliers, customers and host governments 1
Buljevich and Park (1999)
2
The Suez Canal was built on a PF basis as were the UK’s North Sea oilfields.
3

conceptual research as leading to high agency costs.
3
To make these points in greater detail, the remainder of my dissertation is
structured in five additional chapters. Chapter 1 reviews the theoretical and empirical
literature on project finance. Chapter 2 reviews the theoretical and empirical literature on
capital structure, underinvestment and transaction costs. Chapter 3 follows on with
statements of the key propositions of this research, that project finance reduces costs from
underinvestment and transaction costs and derives empirically testable hypotheses.
Hypotheses most important to this dissertation include, “Firms with risky debt
outstanding have a high propensity to undertake project finance.” and “Supplier and
Buyer concentration increases the propensity for project finance.”
Chapter 4 describes the data and the methodology of data collection. Chapter 5
explains how these and related hypotheses are to be tested. It lays out the econometric
models and the econometric issues arising from the possibility of omitted variables and
the independence of individual observations. Chapter 6 lays out and discusses the results
of this empirical investigation.
4
Chapter 1: Literature Review of Project Finance

Theoretical research (Nevitt (1979) and others) and empirical research (Megginson
and Kleimeier (2000), Esty (2003)) shows that project finance is indeed a distinct form of
financing with unique characteristics. Sections 1.1, 1.2 and 1.3 of the review lays out
these characteristics of project finance. The use of project finance and its persistence
through history and into modern times indicates that project finance indeed serves an
economic purpose. Theoretical research into the economic determinants of project
finance reveals at least six distinct theories about the economic problems that project
finance solves.
Project finance has been posited as a means of allocating optimal ownership over
specific assets by Habib and Johnsen (1996). This theory is explored in Section 2.1.
Analysis of managerial decisions leads Chemmanur and John (1996) to posit that the

The following table summarizes the main theoretical and empirical research in
project finance. I have organized the table to reveal the research in underinvestment and 6
Myers (1977), E Berkovitch and Kim, E. H., (1990), Klein, Crawford and Alchian (1978), Bronars and
Deere (1991), Esty (2002).

6
the hold-up problem. The table also highlights the gap in empirical research in project
finance as a solution to the underinvestment problem or the hold-up problem.
Table I: Summary of Theoretical & Empirical Literature

Underinvestment –
Debt Overhang
Transaction Cost
Economics
Project Finance
Theoretical
Research
− Modigliani, F.
and M. H.
Miller, 1958
− Fama, E., 1978
− J. C. Stiglitz,
1969
− J. C. Stiglitz,
1974
− Smith C., and
Warner J., 1979

H. Meckling, 1976
− Klein, B., Crawford,
R., Alchian, A.
(1978)
− Baldwin C., (1983)
− Titman Sheridan,
(1984)
− Grossman S., and
Hart O., (1986)
− Riordan Michael
(1989)
− Stulz R., (1990).
− Wiggins Steven
(1990)
− Bronars S., and Deere
D., (1991).
− Perotti E. and Spier
K., (1993).
− Hermalin and Katz
(1993) Subramaniam
V., (1996)
− Edlin and
Reichelstein (1996)

− J. W. Kensinger
and J. D. Martin,
1988
− T. A. John and K.
John, 1991
− S. Shah and A. V.

Jarrell G. A.,
− Titman S., and Opler
T., 1993
− Megginson W. L.,
and Kleimeier S.,
7
are not included in
project finance.)
Kim E. H., 1984
− Lang L., Ofek E.,
and Stulz R.,
1996
− Parrino and
Weisbach, 1996.
− Morgado A. and
Pindado J., 2002.
− Lehn K., and
Poulsen A., 1989.
− Lieberman M.,
(1991)
− Levy D., (1985)
− Kelly T and Gosman
M, (2000)
− Cowley P R., (1986)
− McDonald J., (1985)
− Bronars S., and
Deere D., (1993)
2000
− Richard
Klompjan and

resources or extractive industries and to finance oilfield exploration, for e.g. British
Petroleum raised $945 million to develop the North Sea oilfields, Freeport Minerals
raised $120 million for the Ertsberg copper mines in Indonesia
7
. The Public Utility
Regulatory Policies Act of 1978 heralded the large scale use of project finance in the
electricity generation industry. Independent power producers financed electricity plants
with project finance. The generated power was contractually sold through long term
power purchase agreements. A host of contracts also linked fuel suppliers, contractors
and regulatory authorities. The 1990’s witnessed project finance being used for a wide 7
Esty (2002) p 72.
Project Finance is the financing of a particular economic unit in which a lender is
satisfied to look only to the cash flows and earnings of that economic unit as the
source of funds from which the loan will be repaid and to the assets of the
economic unit as collateral for the loan.

9
range of assets and industries. Project finance has been used to finance theme parks like
the Hong Kong Disneyland theme park, undersea telecommunication cable companies
like the Australia-Japan Cable project, the Euro-tunnel project, the A2 Motorway in
Poland, and Chad-Cameroon Pipeline. Project finance loans have been very successfully
used in the development of the North Sea oil fields, the Ras Laffan LNG project in Qatar,
the Hopewell Partners Guangzhou Highway in China and the Petrozuata heavy oil project
in Venezuela. Certainly some projects have not been financial successes such as the
Channel Tunnel (Eurotunnel) and the Eurodisney theme park in Paris. The box below
shows the structure of a fairly typical project, the $2.55 Billion Ras Laffan LNG project
in the state of Qatar.

Contracts
EXIM Bank loan
guarantee
265 TCF gas
reserves in
Qatar’s North
Field
Equity

10
a year and that Qatar’s North Field is so large that ExxonMobil engineers actually had to
take into account the curvature of the earth’s surface when designing the project’s
infrastructure. Ras Laffan also shows that a large portion of the $2.55 B investment
comprises debt; $1.2 B. Project finance leverage is typically higher at about 70%. Ras
Laffan also shows that equity investors incorporate a separate project company – Ras
Laffan LNG Company and their composition reflects aspects of vertical integration. A
very large proportion of the project’s output (4.9 Million metric tons of gas out of total of
6.6 Million metric tons or 74.44%) is purchased by a single customer, Korea Gas which
also has a 5% stake in the project equity. The state of Qatar through Qatar Petroleum and
Japanese customers for the project, also have equity stakes in the project. The project’s
output is guaranteed for purchase through long term (25 year) contract and a host of
contracts for engineering and procurement lower risks. The presence of multilateral
funding institutions completes the picture with EXIM bank guaranteeing the debt.
Therefore, Project finance exhibits separate incorporation, high debt levels, long term
contracts, buyers/suppliers purchasing/selling large levels of output/inputs and vertical
integration. The next section explores some project finance loan characteristics.
1.3 Project Finance loan characteristics
Megginson and Kleimeier’s (2000) empirical study of project finance from a data
set comprising other types of syndicated credit lending (corporate control loans, capital
structure loans, fixed asset based loans, and general corporate purpose loans) shows that

Basis points
Project
Finance
Loans

Capital Structure
Loans
Fixed Asset
Based Loans
Corporate
Control
Loans
General
corporate
loans
Not to Scale
12
g) Interestingly PF loans have a lower spread than corporate control loans used to
fund acquisitions, leveraged buyouts, and employee stock option plans which
have a spread of 195 basis points.
h) PF loans are priced at about the same spread as that of capital structure loans
(those booked in order to repay maturing lines of credit or for recapitalizations,
share repurchases, debtor in possession financing, standby commercial paper
support, or other refinancing) at about 135 basis points over LIBOR.
i) Loan size does not seem to impact the spread over LIBOR for project finance
while it impacts corporate finance loans. An increase of $100 million in a project
finance loan decreases the spread by 5 basis points.
j) A project finance loan exhibits a reduction in spread if the maturity is increased
by a year while a one year increase in the maturity of corporate debt exhibits an
increase in spreads. Thus the impact of a maturity increase on a project finance

k) Term to maturity
l) Debt/Equity ratio
m) Whether loan was extended in the same currency as that of income generated by
the project.
14
Klompjan and Wouters use a correlation matrix to investigate the relationship
between the event of default and the explanatory factors. They show that four factors,
presence of commercial risk cover, experience of sponsor, proven technology and debt
service coverage ratio, are significantly correlated with an event of default. Klompjan and
Wouters find that a project is less likely to default if the sponsor has prior experience and
the debt service coverage ratio is high. Proven technology also causes the probability of
default to fall. However, the presence of commercial risk cover increases the probability
of default. Klompjan and Wouters believe that the presence of commercial risk cover
indicates a higher commercial risk and therefore increases the probability of default.
Klompjan and Wouters however point out that their data belongs to the portfolio of only
one bank, that the transactions are still running and therefore future defaults could change
the results. The next section lays out the theoretical literature explaining the determinants
of project finance.
15
Chapter 2 : Theories of Project Finance

Project Finance as a unique financing structure has received considerable attention in
the theoretical literature. The main theories are as follows;
a. Habib and Johnsen (1999) have posited that project finance is a means of
allocating optimal ownership over specific assets. The particular financing
structure of project finance enables investors to hand control over of project
financed assets to ‘redeployers’ in a state of the world where the primary use of
the asset has lost value. The redeployer is skilled in the alternate use of the asset.
b. Chemmanur and John (1996) analyze project finance through the lens of control
benefits to management.

Habib and Johnsen argue that lenders and lessors are asset redeployers. In the event of the
bad state of the world occurring, these asset redeployers change the use of the asset and
generate cash thereby creating value. Debt therefore acts as a means of transferring
control over assets in some states of the world.
Habib and Johnsen (1999) define specific assets as assets with a specified use before
investment.
17
Habib and Johnsen argue that once the bad state of the world occurs, rents from
the redeployment of the asset should go to the redeployer. The entrepreneur should not be
in a position to extract rents from the redeployer. Since the entrepreneur is in control of
the asset when the investment is made and before the state of the world is known, he is in
a position to bargain with the redeployer. The redeployer has committed funds upfront by
contracting with the entrepreneur in anticipation of getting rents by redeploying the asset
once the bad state of the world occurs. The possibility of the entrepreneur resorting to
opportunistic bargaining and extracting rents that should go to the redeployer will cause
distortions in the investments made by both, the redeployer and the entrepreneur. Habib
and Johnsen argue that if the parties rely on negotiated spot exchange to transfer
ownership of the asset in the bad state the rents from redeployment are split between
them in some way. The redeployer has an incentive to reduce his investment in
identifying the asset’s next best use because he recognizes that the entrepreneur can
resort to opportunistic behavior.
If there is no possibility of post contractual opportunism by the entrepreneur, the
amount of investment by the redeployer should equal the value of the asset in the critical
state that separates the good and bad states. Habib and Johnsen argue that non-recourse
project finance loans solve the problem of investment distortion caused by post
contractual opportunism. If the good state prevails, the entrepreneur owns the asset which
is used as intended to generate the cash used for repaying the loan. If the bad state
prevails, the lenders repossess the asset, redeploy it and keep the rents arising from the
redeployment. Since there is no ex-post bargaining involved the entrepreneur captures the
surplus in the good state while the redeployers capture the surplus in the bad state. Thus,