Determinants of Successful Loan Repayment Performance in Project Financing

TABLE OF CONTENTS

TABLE OF CONTENTS

ACKNOWLEDGEMENTS

ABBREVATIONS & ACRONYMS

LIST OF TABLES

ABSTRACT

CHAPTER ONE
INTRODUCTION
1.1. Background of the study
1.2. Statement of the problem
1.3. Objectives of the study
1.3.1. General objectives
1.3.2. Specific objectives of the study
1.4. Hypothesis of the study
1.5. Operational Definition Term
1.5.1. Dependent (Explained) Variable
1.5.2. Independent (Explanatory) Variables
1.6. Significance of the Study
1.7. Delimitation/Scope of the study

CHAPTER TWO
LITERATURE REVIEW
2.1. Theoretical review
2.1.1. Theory of project
2.1.2. Theory of project management
2.1.3. Weber’s Least Cost Theory
2.1.4. Experiential Learning Theory
2.2. Credit (project financing)
2.3. The Nature and Role of Credit Market
2.4. Criteria for Successful Loan Repayment
2.5. Determinant of loan repayment performance
2.5.1. Loan processing time
2.5.2. Due diligence Assessment
2.5.3. Credit appraisal study
2.5.4. Credit approval
2.5.5. Credit Documentation
2.5.6. Project Implementation period
2.5.7. Credit follow-up/ supervisory visits
2.5.8. Output product market access
2.5.9. Management skills
2.5.10. Distance from project location
2.6. Empirical Studies
2.6.1. Empirical Evidence in the World
2.6.2. Empirical Evidence in Africa
2.6.3. Empirical studies in Ethiopia
2.6.4. Knowledge Gap

CHAPTER THEREE
RESEARCH DESIGN AND METHODOLOGY
3.1. Research Design
3.2. Population and Sampling Technique
3.3. Types of Data and Tools/Instruments of data collection
3.4. Procedures of data collection
3.5. Methods of Data Analysis
3.5.1. Descriptive statistics
3.5.2. Logistic Regression model

CHAPTER FOUR
RESULTS AND DISSCUSSION
4.1 Mean of Demographic and Socio-Economic Characteristics of the Financed Project
4.1.1 Educational Level of the Project Manager
4.1.2 Managerial Experience of Project Manger
4.1.3 Delayed Project Implementation Period
4.1.4 Input Raw Material Availability
4.1.5 Accessibility of Output Product Market
4.1.6 Type of Management
4.1.7 Distance from Project Location to Input Raw Material
4.1.8 Distance from Project Location to Output Product Market
4.1.9 Type of Market for the Commodity Financed
4.2 Institutional Factors
4.2.1 Loan Processing Time
4.2.2 Loan Amount
4.2.3 Number of Project Follow-Up
4.2.4 Equity to Debt Ratio
4.3 Correlation (Relationship) between Dependent Variable with Explanatory Variables
4.3.1 Educational Qualification of the Project Manager
4.3.2 Managerial Experience of Project Management
4.3.3 Delayed Project Implementation Period
4.3.4 Raw Material Availability
4.3.5 Output Product Market Accessibility
4.3.6 Type of Management
4.3.7 Type of Market for the Commodity Financed
4.3.8 Loan Processing Time
4.3.9 Number of Project Follow-Up
4.3.10 Equity-to-Debt Ratio
4.3.11 Distance from Project Location to Raw Material Availability
4.3.12 Distance from Project Location to Output Product Market
4.4 Determinants of loan repayment in project financing
4.4.1 Discussion of the Significant Explanatory Variables

CHAPTER FIVE
CONCLUSIONS AND RECOMMENDATIONS
5.1 Conclusion
5.2. Recommendation and Policy implication

REFERENCEs

APPENDIX A

APPENDIX B

Correlation Coefficients

ACKNOWLEDGEMENTS

First, I would like to thank almighty God, the Compassionate, the Most Merciful and Source of Knowledge & Wisdom, who bestowed upon me the health, the power of communication and the courage to accomplish this thesis.

Next to God, I would like to express my sincere gratitude to my advisor Tesfaye Hirpasa (PhD) for his continuous support of my MBA thesis, for his patience, kindness, encouragement, motivation, eagerness, and immense knowledge. His guidance helped me in all the time of conducting the research up to writing of the thesis.

Thirdly, I would like to thank my brothers Solomon Gezahegn for his encouraged assistance and provided me SPSS software manual and for Firew Teshome, Wondemagegn Teshome and Anteneh Tesfaye were provided various documents and always willing to help and give their best suggestions throughout my study. My appreciation also goes to Fikirte and Getie provided me individual borrowers file to collect the data.

Last but not the least; I would like to thank my mom Zerfe Daseta and my wife Samrawit Tibabu for their encouragement and support and also thanks my brother and sister for their support and encouragement throughout my education life.

ABBREVATIONS & ACRONYMS

AM Accessibility of Market

AML Amount of loan

ARM Availability of raw material

DRS Debt rating scale

DBE Development Bank of Ethiopia

DFPLRM Distance from project location to raw material destination

DFPLPM Distance from project location to output product market

EL Educational level

EDR Equity debt ratio

ELT Experiential Learning Theory

LPT Loan processing time

MEPM Managerial experience of Project manager

NPF Number of Project Follow-up

PIP Project Implementation period

PMB Project Management book

SLR Successful loan repayment

TM Type of management

TMFCF Type of market for the commodity financed

WBS Work breakdown structure

LIST OF TABLES

Table 1 Mean of Educational Level

Table 2 Mean of Managerial Experience of Project Manger

Table 3 Mean of Delayed Project Implementation Period

Table 4 Mean of Input Raw Material Availability

Table 5 Mean of Accessibility of Output Product Market

Table 6 Mean of Type of Management

Table 7 Mean of Distance from Project Location to Input Raw Material

Table 8 Mean of Distance from Project Location to Output Product Market

Table 9 Mean of Type of Market for the Commodity Financed

Table 10 Mean of Loan Processing Time

Table 11 Mean of Loan Amount

Table 12 Mean Of Number of Project Follow-Up/Supervisory Visit

Table 13 Mean of Equity-to-Debt Ratio

Table 14 Relationship with Educational Level

Table 15 Relationship with Project Management Experience

Table 16 Relationship with Delayed Project Implementation Period

Table 17 Relationship with Raw Material Availability

Table 18 Relationship with Output Product Market Accessibility

Table 19 Relationship with Type of Management

Table 20 Relationship with Type of Market for the Commodity Financed

Table 21 Relationship with Loan Processing Time

Table 22 Relationship with Number of Project Follow-Up

Table 23 Relationship with Equity-to-Debt Ratio

Table 24 Relationship with Distance from Project Location to Raw Material Availability

Table 25 Relationship with Distance from Project Location to Market

Table 26 logistic regression

ABSTRACT

This study assesses the determinants of successful loan repayment performance of project financing in the case of Development Bank of Ethiopia. The study used explanatory design and quantitative research approach. Secondary data was used. The collected data were taken from individual borrowers’ files. Hence the total sample size was seventy five (75), of which 40 (53%) were successful financed projects (non-defaulters), whereas the rest 35 (47%) were non-successful ones (defaulters).Data was analyzed via correlation followed by logistic regression model using SPSS version 20. The independent variables used in the study are accessibility of market, amount of loan, availability of raw material, distance from project location to raw material destination, distance from project location to output product market, educational level, equity debt ratio, loan processing time, managerial experience of project manager, number of project follow-up, project implementation period, type of management and type of market for the commodity financed. In the study, logistic regression model was used to identify variables which determine successful loan repayment performance. The paper reveals that the managerial experience of project managers, loan processing time , educational level, number of project supervisions/ follow-ups by the bank, delay in project implementation period and type of management for the financed projects were statistically significant determinant of loan repayment performance of DBE’s financed projects. This study suggests that Development Bank of Ethiopia better intensify its project monitoring and follow-up work in order to make well-informed decisions and provide technical assistance for its credit-assisted projects ; give due attention to minimize the bureaucracy that delays the loan processing time; critically analyze the project implementation period at the time of appraising projects and enhance its project implementation capacity; identify and redress the root causes of project delays; and improve its efficacy of customer recruitment system by giving special considerations to educational level of borrowers, managerial experience of project managers and type of management, among others .

CHAPTER ONE

INTRODUCTION

1.1. Background of the study

Loan means any financial facts of a Bank arising from a direct or indirect advance or commitment to advance funds by a Bank to person that are conditional on the obligation of the person to repay the funds either on specified date or on demands usually with interest (Adrian & Ciornelis 1990).

Since loan portfolio is the largest asset and predominant source of revenue, effective management of credit function is fundamental to the Bank safety and soundness (Adrian & Ciornelis 1990).

Financial sectors play a critical role for the growth and development of a country. One of the financial institutions that play an intermediation function by mobilizing money from those who have excess fund and lend it to others who need it for their investment are Banks. As a result, providing credit to borrowers is one means of which Banks contribute to the growth of economy, thereby ensuring that the money available in economy is used for productive and fertile project purpose which can stimulate the economy as well. Hence, proper management of credit not only has positive effect on the Banks performance but also on the borrower firms and a country as a whole.

For that reason, Bank lending is guided by credit policies which are guidelines and procedures put in place to ensure smooth operations. Bank lending, if not properly assessed, involves the risk that the borrower will not be able to pay or willing to honour their obligation (Martin, 2007). In order to lend, Banks accept deposit from public against which they provide loans and other forms of advances and bear a cost for carrying this deposit. Banks undertake lending activities in order to generate revenue. The major source of revenue comprises margin, interest, fees and commission (Martin, 2007).

Beyond the urge, to extend credit and generate revenue, Banks have to recover the principal amount in order to ensure safety of depositors` fund and avoid capital erosion. Bank lending therefore, has to consider interest income, cost of funds, statutory requirement, and depositor needs and risk associated with loan proposals. For these reasons Banks have overtime developed credit policies and procedures which stipulate the lending process. This process includes among others the credit appraisal, documentation, disbursement, and monitoring and recovery process of lending. However, Banks have continued to face an average of between 20-40% bad debt written off yearly (Martin, 2007).

Development Bank of Ethiopia is one of the financial institutions play a critical role for the growth and development of a country. It is a specialized Bank established to spur the national Development agenda. The Bank’s focal point is the provision of customer focused lending to viable projects in line with government priority areas by mobilizing fund from domestic and foreign sources while ensuring its organizational sustainability. Hence the ability to collect the amount of loans disbursed to the client is crucial for the long term sustainability of project financing institution like DBE.

When it comes to the history of the Development Bank of Ethiopia, it goes back to 1909, and currently the key mandate of the Bank is the provision of Development credit to viable priority area projects along with technical support and advice by mobilizing resources from domestic and foreign sources. DBE continued to extensively provide financial and technical support to government priority economic sectors i.e. commercial agriculture, agro-processing, manufacturing and extractive industries. As it has been doing for over hundred years, DBE has remained dedicated to assisting the development endeavors of the country through availing ­ financial and technical assistance to viable projects in accordance with government policies. However, availing loan to borrowers is not an easy task; this is because of the high financial risk of the Bank as a result of failure to collect the disbursed loan from the customers. Currently the Bank has Head office, 12 regional offices (districts), 110 branches strategically located all over the country for its smooth operation. The Bank, from its inception up to now renders in project financing and lease financing in different sectors like commercial agriculture, Agro processing, Manufacturing and extractive industry.

According to the respective years’ Annual Performance Report of the Bank of 2016, average loan recover performance of the Bank for the period 2012/13 to 2016/17 shows 55%. As a result, such huge gap experiencing in the Bank leads to reduction of the profitability of the Bank and even hinder economic growth of the country as it goes by this rate.

Therefore, this paper analyzed the determinant of successful loan repayment performance in project financing through different determinants and contribute to loan collection of DBE and suggested sound strategy for decision makers on how to increase the loan collection of the Bank.

1.2. Statement of the problem

Effective control of loan repayment is critical for sustainable and healthy growth of the Banking sector especially for those predominantly engaged in provisioning loans. In other words, the determinants of successful loan repayment performance in project financing have to be properly investigated because the survival and the sustainable operation of such institutions are directly influenced by these factors. Therefore, investigation of the major determinant for successful loan repayment of Banks is especially essential for project financing Banks.

Any loan granted by a financial institution is generally provided at a cost, referred to as interest on the debt, which is the primary incentive for the lender to engage in this loaning activity. And In such loan, each of these obligations and restrictions is enforced by a contractual agreement or loan covenants between these stakeholders that clearly states the rule of the game agreed upon by both parties on the different aspects including the purpose, disbursement schedule, repayment period and the charges associated with the loan.

In the area of loan repayment performance researches have been done by Kibrom (2010), Mulugeta (2010) and Muluken (2014) under the Development Bank of Ethiopia. Kibrom, (2010) research had been conducted on Mekele branch specific to private borrowers. Mulugeta, (2010) research had been conducted specific to agricultural borrowers. Muluken, (2014) on his research had been conducted specific to floriculture growers’ borrowers. This research work is differing from that of the above mentioned researchers in that: it has included all sectors of the financed project at head office; as a result it represents the big picture of the Bank. Because the total loan portfolio concentration at head office takes a share of 85% which is the Bank`s representative. Secondly, the collected data of successful financed project were taken from the settled financed project to identify the success factors, whereas those researchers have used only the status of the project on the period in which they have conducted to measure the success factors of their research works. Hence, the researches output could not fill up the gap on loan repayment performance of the Bank.

As per data obtained from the central database of the Bank, the loan recovery performance trend for the last five years 2012/13, 2013/14, 2014/15, 2015/16 and 2016/17 shows 41%, 60%, 51%, 41% and 55% respectively (Central Database of Development Bank of Ethiopia annual reports of 2016/17). This shows that the average yearly loan collection of the Bank (nearly 50%) could not cover the total amount of demand/due. Additionally, the NPL ratio of medium and long term loans of the Bank for the last five years 2012/13, 2013/14, 2014/15, 2015/16 and 2016/17 shows 9.73%, 8.36%, 8.62%, 8.2% and 12.54% respectively. Despite such a huge gap, no representative study at national level has been done to investigate the factors that contribute to the poor performance in loan recovery through assessing the successful projects financed by the Bank.

It is the aforementioned evidence that motivated the researcher to identify the major factors that determine successful loan repayment performance in the Development Bank of Ethiopia.

There were few other studies that have been conducted on the determinant of loan repayment performance under micro finance institutions in Ethiopia by, Abraham,(2002), Jemal, (2003), Mengistu (1997) and Bekele et al. The research works largely focus on repayment performance of smallholder farmers in case of different microfinance and NGOs in different region of the country. As per DBRS( Debt Rating Scale) policies short-term creditors, by granting loans, assume less risk than long term creditors because there is less chance of substantial change in the financial soundness of the creditors within a few week’s or month’s time. Thus, this study has mainly focused on identifying the determinants of medium and long term project financing whereas the above stated research works have generally emphasized on short term loans. Hence, the study has focused on this important issue and has investigated and believed to have a positive outcome for the manager’s of Development Bank of Ethiopia and the policy makers and regulators in general.

Therefore, the main purpose of this study is to analyze determinants of successful loan repayment performance and explore the determinants of successful loan repayment by taking a project financed borrowers’ financial data from Development Bank of Ethiopia. The outcome of the research could enable the Bank to know the key determinants for successful project financing and act accordingly. Moreover, logistic model has been employed to quantitatively examine the determinants of successful loan repayment in the case of Development Bank of Ethiopia.

1.3. Objectives of the study

1.3.1. General objectives

The main objective of the study is to identify the determinants of successful loan repayment performance in project financing in the case of Development Bank of Ethiopia.

1.3.2. Specific objectives of the study

- To identify significant factors that determines successful loan repayment of project financing in the Development Bank of Ethiopia.
- To see the relation between successful loan repayment of project financing and associated factors in the Development Bank of Ethiopia.

1.4. Hypothesis of the study

Various quantitative research proposals and writers use research questions Habtamu (2012). On the other hand, a more formal statement of a research employs hypotheses. These hypotheses are predictions about the outcome of the results to be estimated (more or less high, lower of something). Therefore, the study has been tested based on following hypotheses.

- Hypotheses 1: successful loan repayment of the clients is positive and has significant relationship with loan possessing time.
- Hypotheses 2: type of management is positive and has significant relationship with successful loan repayment of the clients.
- Hypotheses 3: there is a positive and significant relationship between managerial experience of project manager and successful loan repayment of the clients.
- Hypotheses 4: client`s successful loan repayment is positive and has significant relationship with education level.
- Hypotheses 5: equity to debt ratio is positive and has significant relationship with successful loan repayment of the clients.
- Hypotheses 6: number of project follow–up has positive and has significant relationship with successful loan repayment of the clients.
- Hypotheses 7: successful loan repayment of the clients has positive and significant relationship with delayed project implementation period.
- Hypotheses 8: type of market for the commodity financed has positive and significant relationship with successful loan repayment of the clients.
- Hypotheses 9: there is a positive and significant relationship between amount of loan and successful loan repayment of the clients.
- Hypotheses 10: client`s successful loan repayment is positive and has significant relationship with availability of raw material
- Hypotheses 11: distance from project location to input raw material is positive and has significant relationship with successful loan repayment of the clients.
- Hypotheses 12: market accessibility to the output products is positive and has significant relationship with successful loan repayment of the clients.
- Hypotheses 13: client`s successful loan repayment is positive and has significant relationship with distance from project location to output product market

1.5. Operational Definition Term

1.5.1. Dependent (Explained) Variable

Successful Loan Repayment (SLR) It is measured as a dummy variable and has been measured for all the financed project borrowers’ that have fully repaid their loans according to the contractual agreement. One (1) indicates those financed projects that have fully paid its debt based on the contractual agreement from the cash flow of the project. Zero (0) indicates those financed projects that do not able to pay its debt based on the contractual agreement.

1.5.2. Independent (Explanatory) Variables

Number of Project Follow-up (NPF) it is a discrete variable and been measured in number of supervisory project visits of the project by Bank’s credit officers per annum. It is essentially intended to closely monitor the project implementation and/or operation, thus recommends any corrective measure if deemed necessary. Visits by loan officer to borrowers are encouraged the borrowers’ to work harder and make sure the loans given to them are effectively utilized for the planned investment activities. This is also supported by the empirical studies of Koopahi and Bankhshi (2002), Wongnaa and Awunyo (2013), Mulugeta(2010) and Muluken(2014).

Equity to Debt Ratio (EDR) it is a continuous variable defined as the ratio of equity/ initial capital contributed by the borrower to the total loan approved by the Bank. It is assumed that the ratio of equity to debt increases, the borrower becomes more dedicated to the implementation of the project. This in turn has a positive impact on the sustainability of the project. Hence it is predictable that to have a positive impact on loan repayment performance. It is supported by Mulugeta (2010).

Managerial Experience of Project Manager (MEPM) it is a continuous variable assumed that as the projects are managed by highly experienced managers; it could overcome different challenges and this makes the project to be profitable and successfully paid its debt. Borrowers who have been in business longer are expected to be more successful with their enterprise. They have more sales and cash flows than those who have just started. Thus, those who are more experienced would have high repayment rates. This in turn has a positive impact on repayment performance. Hence, the variable is expected to have positive impact on the dependent variable. The hypothesis is supported by the findings of Oladeebo (2008), Wongnaa and Awunyo (2013),Muluken (2014).

Education Level (EL) Level of education (measured in educational status of the borrower). Higher educational levels enable borrowers to comprehend more complex information, keep business records, conduct basic cash flow analysis and generally speaking, make the right business decisions. Hence borrowers with higher levels of education may have higher repayment rates. It is a dummy variable taking the value of 1 if the borrowers/managers have BA/BSC degree and above and 0 for otherwise. Further various researcher were supported by Matin (1997), Kashulize (1993), Njioku and Odii (1991), Oladeebo (2008) and Amare (2002), Michael (2006), Muluken (2014) Ojiako and Ogbukwa (2012),Mulugeta (2010), Eze and Ibekwe (2007), Balogun and Alimi (1988) and Amare (2006) empirical studies noted that education has a positive impact on the repayment performance through increasing awareness of the customer to utilize the loan efficiently. The same result is happen in this study.

Loan processing time (LPT) it is defined as the time taken from the credit project application of borrower to the releasing of disbursement of the loan. If the loan is disbursed on time that is on the possible shortest time, it is unlikely that it would be diverted to non intended purposes. On the other hand the lengthened appraisal and approval process leads to late disbursement of the loan. This in turn has an impact on the delay of implementation of the project. Hence long loan issuing time is expected to have negative effect on repayment performance. This variable hypothesis is supported by the finding of authors Balogun and Alimi (1988), Koopahi and Bakhshi (2002), Bekele (2003), Jama and Kulundu (1992), Hunte (1996), Njioku and Odii (1991), and Mulugeta (2010).

Amount of loan (AML) Defined as the amount of the loan in which the Bank releases to the respective borrowers. It is assumed that if the size of the loan is large, it would increase the interest and charges on the production process and affect the repayment performance negatively. In the contrary Bekele (2003) noted that, if the production capacity of the project can utilize the loan efficiently, it increases the loan repayment performance. Hence, the actual impact of the variable been determined in the analysis. This is also supported by Muluken (2014)

Type of market for the commodity financed (TMCF) Refers to the type of the project in which the loan is fully financed by DBE. It is a dummy variable taking a value of 1 if the project product is export market oriented and 0 otherwise. According to Mulugeta (2010), Muluken (2014) a borrower who has engaged on export markets had a good record of repayment performance than if the commodity was produced for local market. It is expected to have a positive relationship with the dependent variable.

Delayed Project implementation period (DPIP) it is defined as the time frame in which the implementation of its establishment investment activities are undertaken. It is the period from the laying the foundation to the commencement of operation. Financed project operation started period. It is a categorical variable taking a value of 1 for the financed project operation stating period up to six month, 2 for project operation more than six month but less than one year and 3 for project operation exceed one year. It is assumed that projects in which lately implemented projects have lower repayment rate than implemented based on the expected period under the appraised document.

Type of management (TMGT): It is defined as the type project manager (either owner or employed) who is responsible for the overall operation of the project. It is a dummy variable which takes 1 if the project is managed by the owner manager and 0 otherwise. It is expected that if the project managed by the owner, they could take the responsibility and make correction timely at the time of facing the problem. This makes the project to be sustainable as a result the borrowers have paid its debt based on the contract. This in turn has a positive impact on the successful loan repayment performance. Hence, type of management is expected to have positive sign. It is supported by Muluken (2014)

Distance from Project location to input raw material (DPLRM). It is continues variable and measured by distance. It is the distance between the locations of the project to the place where the input raw materials are available. It is assumed that the availability of input material are very close to the project site, various logistics costs have decreases this in turn the project can able settle its debt based on the contract agreement.

Distance from Project location to output product market (DPLPM). It is continues variable and measured by distance. It is the distance between the locations of the project to the place where the output product market is accessible. It is assumed that the accessibility of output product market (the place where the target consumer) are very close to the project site, various logistics costs have decreases this in turn the project can able settle its debt based on the contract agreement.

Availability of raw material (ARM); it is a dummy variable taking 0 for borrowers that do not have available input raw material and 1 for borrowers that have available input raw material. Over the past few years, highly unstable prices in commodities markets have put financial pressure on many producers. Between 2003 and 2008, prices for many of the raw materials used for making industrial products (such as crude oil, steel and aluminum) and consumer packaged goods (such as paper, wheat and milk) rose at double-digit rates only to fall dramatically in the following year. Some sectors have recovered while others remain depressed, but the consensus is that more volatility and uncertainty can be expected going forward (Shulman J et al., 2010). As a result of availability of input raw material the price of the product might constant or even less and the productivity of the company is enhanced and this might help the borrower to have successful loan repayment performance.

Accessibility of output product market (AM); it is a dummy variable taking 0 for borrowers that do not have access output product market and 1 for borrowers that do have access output product market.

1.6. Significance of the Study

According to the data obtained from central database of DBE, the loan recovery performance report of the Bank shows 55% as at June 30, 2017. This has an impact on the sustainable provision of credit to the potential investors and existence of the Bank as a financial institution. It is therefore, important for the financial institutions to devise a means of enhancing loan collection performance of the Bank. This can be achieved if the Bank identifies the determinants of successful loan repayment performance in project financing. Thus this study is for:

- Policy makers to formulate successful credit policies and programs that would in turn help in allocating financial resources effectively and efficiently.
- Managers clearly understand the extent to which the impact of loan possessing time, number of project follow-up, project implementation period, amount of loan, education level, type of management, type of market for the commodity financed, managerial experience of project manager, equity to debt ratio, availability of raw material, distance from project location to input raw material, market accessibility, and distance from project location to output product market for the loan repayment performance.
- The management of the Bank can understand the determinants of successful loan repayment performance and evaluate the loan repayment performance.
- Helps other researchers to identify the factors behind successful loan repayment and to make research on related issues.

1.7. Delimitation/Scope of the study

The study is limited to Bank specific factors even though macroeconomics has a huge impact on loan repayment performance. Thus the study has explored Bank specific factors determining successful loan repayment in project financing. Hence the study covered the repayment aspect of Development Bank of Ethiopia and focused on the explanatory variable and the dependent variable like loan possessing time, number of project follow-up, project implementation period, amount of loan, education level, type of management, type of market for the commodity financed, managerial experience of project manager, equity to debt ratio, availability of raw material, distance from project location to input raw material, market accessibility, and distance from project location to output product market were associated with loan repayment. Borrower data have been taken only for the projects in which the Bank has financed between 2004/05 and 2008/09 fiscal year. This is because the credit terms of the financed projects were either medium or long term; as a result, to determine the success or fail factors of the projects it is mandatory to go back to the loan rendered period of the project to review the current status. The scope of the study has been restricted only to Head office borrowers’ of Development Bank of Ethiopia, due to the portfolio of the Head office loan takes a lion share which is 85% of the total loan portfolio of the Bank. (DBE, 2015)

CHAPTER TWO

LITERATURE REVIEW

These sections have two parts which is the theoretical and empirical literatures so as to analyze and identify the main determinants of successful loan repayment.

2.1. Theoretical review

2.1.1. Theory of project

Turner (1993) referenced in the (Project Management book) PMB Guide as starting point for a reconstruction of the theory of project. According to Turner, scope management is the raison of project management. He describes the purpose of scope management as follows: (1) an adequate or sufficient amount of work is done; (2) unnecessary work is not done; (3) the work that is done delivers the stated business purpose. The scope is defined through the work breakdown structure (WBS).What does Turner say, from a theoretical point of view? Firstly, he (absolutely) claims that project management is about managing work; this is the conceptualization. Secondly, he claims that work can be managed by decomposing the total work effort into smaller amount of work, which is called activities and tasks in the PMB Guide. Thirdly, he claims that this conceptualization and the principle of decomposition serve three essential purposes of project management. Even if not mentioned by Turner, there is an important, but implicit assumption associated with decomposition, namely that tasks are related if at all by sequential dependence. Indeed, a review of the PMB Guide reveals that activities and tasks are the unit of analysis in the core processes of project management, like scope management, time management, and cost management, and that their management and control is centralized. This is also supported by the description of Morris of the classic - and still current - project management approach as follows Morris (1994).

2.1.2. Theory of project management

A theory consists primarily from concepts and causal relationships that relate these concepts Whetten (1989). It is possible to broadly characterize a target theory of production/operations management (Koskela 2000). This categorization applies also for project management, being a special type of production/operations management. A theory of project management should be authoritarian: it should disclose how action contributes to the goals set to it. On the most general level, there are three possible actions: design of the systems employed in designing and making, control of those systems in order to realize the production intended and improvement of those systems. In fact Project management and all production, have three kinds of goal. Firstly, the goal of getting intended products produced in general. Secondly, there are internal goals, such as cost minimization and level of utilization. Thirdly, there are external goals related to the needs of the customer, like quality, dependability and flexibility.

2.1.3. Weber’s Least Cost Theory

Alfred Weber (1868-1958) formulated a theory of industrial location in which an industry is located where it can minimize its costs, and therefore maximize its profits. Weber’s least cost theory accounted for the location of a manufacturing plant in terms of the owner’s desire to minimize three categories of cost:

1) Transportation: the site chosen must entail the lowest possible cost of A) moving raw materials to the factory, and B) finished products to the market. This, according to Weber, is the most important.
2) Labor: higher labor costs reduce profits, so a factory might do better farther from raw materials and markets if cheap labor is available.
3) Agglomeration: when a large number of enterprises cluster (agglomerate) in the same area (e.g. city), they can provide assistance to each other through shared talents, services, and facilities(e.g. manufacturing plants need office furniture)

2.1.4. Experiential Learning Theory

According to Norel (2001), one of the strategies that lending institutions can use to reduce the rate of default by borrowers is through training. Training to the clients prior to the transaction of each loan and financial incentives for the credit officers can be used to instill a culture of loan repayment. The trainers must be able to take into consideration the nature of the learners and what kind of behavior they want the learners to adopt. Thus being aware of the need to direct the borrowers to practice regular behavior of commitment and repayment of their loans there is need to borrow from Kolb’s Experiential Learning theory.

According to Kolb and Kolb (2008), the experiential learning theory can be applied to all aspect of life, all age groups, by different cultures and different kinds of organizations. Kolb and Kolb (2008) describe research on experiential learning to have used ELT (Experiential Learning Theory) to describe the management process as a process of learning for individuals, teams, organizations to solve problems and make decisions, identify entrepreneurship opportunities and seeking a strategy formulation. ELT is based on the proposition that learning is a holistic process of adaptation. It should not only be taken as a result of cognition but includes integrated functioning of the total person –thinking, feeling, perceiving and behaving.

2.2. Credit (project financing)

Credit is defined as the power or ability to obtain goods and service in exchange for promise to pay for them later (Beckman and Foster, 1969). In a similar manner, credit is the power or ability to obtain money, through the crediting process, it come back for the promises to repay the obligation to obtain money, by the borrowing process, in return for the promises to repay the obligation in the future. Project financing is necessary in a vibrant economy because of time elapsed between the production of goods and its ultimate sale and consumption. The risk in extending credit is the probability that future payment by the financer of the project will not be made.

According to the financial institutions, formal financial institutions are regulated by central Bank supervisory authority for licensing and accomplishment of credit policy. They usually use legal documents or legal systems to enforce contracts. Formal credits are those released by financial institutions that are arranged and legally occupied in the provision of credit and mobilization of saving. In the context of Ethiopia, these institutions are regulated and controlled by the National Bank of Ethiopia (NBE). In the contrary, informal credits are provided by individuals, organizations and institutions that operate outside the legal Banking system and control of the national Bank. According to Bekelle, 1995, informal credit sources are categorized as commercial (those who lend money on short term basis to obtain profit) and non commercial (lenders that generally include friends, relatives and neighbors). Mutual help associations including are Idir, Iqub, modern cooperatives, NGOs, etc categorized on the potential source of informal financial services.

Successful borrowers/non-defaulters is credit worthy borrowers who paid/settled the due/debt amount on the due date signed on the contract. This entails that the clients are dedicated on the credit agreements made with the lending institution. Defaulters are non credit worthy borrowers who breach their loan contract and have repayment problem on the due date (Hunte, 1996).

2.3. The Nature and Role of Credit Market

Finance is fundamental to begin and operate productive activity. Sufficient funding is a requirement for proper organization of production, attaining of investment assets and/or raw materials and Development of marketing outlets etc. Credit is a device for facilitating transfer of purchasing power from one individual or organization to another. Oyatoya(1983) credit offers the basis for increased production efficiency through specialization of functions, thus bringing together in a more productive union, the skilled labor force with small financial resources and those who have substantial resources but lack entrepreneurial ability.

The relationship between credit and economic growth has captured the attention of economists since long (Schumpeter, 1933). Through enhanced financial intermediation, the amount of financial savings that is diverted by the financial system into non-productive uses fails, and the rate of capital accumulation increases for a given saving rate (Mensah, 1999). Further elaborates the significance of financial intermediation improves saving mobilization, as long as a variety of safe financial instruments to savers and ensuring substantial returns on savings. The financial sector contributes to the efficiency of the entire economy through scattering information about expectations and allocation of resources to investors.

Mensah (1999) expressed the importance of credit management as follows: credit management process required special emphasis due to proper credit management greatly influences the success or failure of financial institutions. An understanding of a Bank’s credit risk management process provides lending indicator of the quality of a Bank’s loan portfolio. The major elements of effective credit management have well developed credit policies and procedures, strong portfolio management; effective credit controls and the most crucial of all a well trained staff that is qualified to implement the system. Those institutions must preserve basic credit standards to function well and make credit available to investors. The standards include in-depth knowledge of the borrowers` project by the officer in charge; reasonable debt equity ratio, marketability, viability of the investment project and other technical capabilities. In general Credit appraisal is fundamental for the officer to decide about the credit worthiness of the borrower as well as the project to which the finance is injected.

2.4. Criteria for Successful Loan Repayment

According to William (2007), there are certain criteria that most project financing r requires the business owner to meet it objectives the funds has to be released if the business needed. These hurdles or requirements are generally categorized as: Good Credit, Equity, Experience, Business Plan, and Collateral.

The above mentioned list of credit requirement five guidelines of successful borrowers are reviewed as follows;

Good Credit – it deals with the requirement that one must have worth credit history which is not only good, but more to the outstanding side of the scale. The logic behind for the this lender requirement according to the writer is that, at any time borrowers are might coming to Banks and borrowers applying for loans for a variety of reasons. The credit officer and the lending institution's management have an obligation to manage the project to the positive benefit of the owners and the Bank. Thus, at the time of injection of a loan should be provided only to those who have the least risk of failure to repay. Past repayment history (i.e. good credit) is the first and probably the most important requirement for a successful loan.

Equity- in borrowing can be thought of as similar to a down payment. The lender wants the borrower to have a financial commitment to the venture for which the loan is requested. The writer say that the borrower has to have some “skin” in this business “game” to insure his or her best efforts toward success and timely repayment of the borrowed funds. The capital investment is seen also as a proof for shareholder’s commitment in the business.This is to say, that even if all the other four criteria for successful borrowing; credit, experience, business plan, and collateral are met; the Bank usually will not lend 100 percent of the funds requested.

Experience-According to William (2007), no rational lender wants to or will turn over monies to a borrower to manage and expend in a business or venture in which the person has no or very limited experience. This measure for successful borrowing should be easy to see from both the lender and borrower’s point of view. Lenders need to be more certain that the person or persons borrowing the funds have the experience and expertise to manage the money and in the day to day the business is conducted in a careful manner. It is needed to cover positive results from the business and further indemnify that the lender will be repaid with interest and in a timely manner. The more experience and talent the borrower has shown in the past, the lower the risk in lending from the Bank’s point of view. The minimum numeric value often expected here is that the borrower should have at least three years of experience in the management of the type of business in whose name he or she is borrowing the funds. This experience can be as an owner and/or management experience. It could also be experience as an employee in a similar type business.

Business Plan- The fourth requirement of the Bank or lender is in depth analysis has been conducted, at the time of conducting the business plan of the project has to be researched and constructed business plan. This is a document in which:

a) Assumed to be introducing the business in a clear and complete manner;
b) Describes the business ,the potential market for the goods and service to be offered , the existing competition ,states who will be employed ,who will lead and manage and how the borrowed funds will be expended;
c) The good business plan will have pro-forma (estimated) financial documents. These are the cash flow statement, income statement, and balance sheet.

Collateral- Finally according to the writer, after a borrower have shown good credit worthy, put in equity cash or goods, shown he/she have experience in the business and produced a positive cash flow business plan. The lender would be willing to provide money to the borrower based on the fulfilment of appraisal requirement.

Supplementary forms of safekeeping the customer can provide the lender. Giving a lender collateral means that an own asset is mortgaged, such as a property, to the lender with the agreement that it will be the repayment source in case the loan is not repaid from the established sources as per terms and conditions agreed for the financing. A guarantee, on the other hand, is just that - someone else signs a guarantee document promising to repay the loan if the initial lender cannot. Some lenders may require such a guarantee in addition to collateral as security for a loan. Collateral is considered “the second way out” by the lender in case the credit goes wrong. (Dr.Mihaela, 2010)

Collateral according to William (2007) is any asset of value that can be pledged by the borrower(s) as security that the loan will be re-paid in full and with interest. Collateral requirements in the process of borrowing for a business can range up to and above 100 percent of the loan principal. This percentage depends again on the amount of risk that the lender calculates that his institution is exposed from this particular loan and the accumulation of all loans currently in process.

2.5. Determinant of loan repayment performance

2.5.1. Loan processing time

Loan processing time it is defined as the time taking from credit application to first disbursement. The total loan processing time incorporate credit application to first disbursement. To finalize the process the Bank have passed the following four steps of functions have been undertaken such as due diligence assessment, credit appraisal study, credit approval and credit documentation.

2.5.2. Due diligence Assessment

This first steps of analysis of the borrower characteristics to go to the next step. Through conducting in-depth analysis of the creditor the credit officer either accept or reject the credit application based on the Bank criteria set. This is due to potential risk involved in a potential investment, a due diligence assessment is essential to the pre-funding commitment. The biggest investment a lender or creditor can make in a business is taking the time to determine the key aspects of the business environment, from the day-to-day operations practices, to human resource considerations, to the necessary practices to maintain customers. A due diligence assessment provides the answers to these questions, allowing creditors and lenders to decide if they are willing to proceed given the existing factors. As such, it is a helpful tool in making a more informed credit or investment decision.

Due diligence assessments also provide information which can be used when crafting lending or investment instruments for the benefit of lending or investing entities. Although the structure of each engagement is unique, projects typically focus on answering the following questions:

- Market positioning, including competition, capabilities, market dynamics by segment
- Execution capabilities, including strategy, management capabilities, cost structure, customer service, quality, product innovation
- Attainability of business plan and projections
- Cash flow forecast, quality of earnings and debt service capabilities

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