Course Title

Project Engineering

Chapter 6
PROJECT FINANCE

Lecture 11 (Week 11)

Introduction to Project Financing,
Conventional and Project Financing,
Capital Budgeting decisions and Capital
Structure Planning.

Lecturer: Associate Prof Ishwar Adhikari

Learning Objective
The main objective of this lecture is to understand about:
 Introduction of Project Finance.
 Difference between Project Financing and Conventional Financing.
 Capital Budgeting Decisions.
 Capital Structure Planning

Prepared By: Associate Prof. Ishwar Adhikari/Department of Civil Engineering/Kathmandu Engineering

College (Affiliated to Tribhuvan University), Kathmandu, Nepal.
6.1 INTRODUCTION TO PROJECT FINANCE
In simple terms, money borrowed to finance a project can be called as project finance. Project
finance is a method of raising long term debt financing for major projects through “financial
engineering”, based on lending against the cash flow generated by the project alone. [1]In other
words, raising of funds required to finance an economically separable capital investment
proposal in which the lenders mainly rely on the estimated cash flow from the project to service
their loan. [2]
The structure of project financing relies on future cash flows for repayment of the project
finances. It is very much essential for all the stakeholders of a project to understand about
project finance to manage the cash flow for ensuring profits so that it can be distributed among
multiple parties. As the project proposal progresses through the stages of planning, analysis
and selection, the contours of project financing become clearer. [3] In practice, however,
project financing is considered right from the time of the project conception. Project finance is
especially attractive to the private sectors because they can fund major projects off balance
sheet. It includes finance for natural resources projects (mining, oil, gas), independent power
project, public infrastructure (road, transport, buildings etc.) and mobile telephone networks
etc.
Project finance is usually raised for new project rather than an established business. There is a
high ratio of debt to equity, roughly project finance debt may cover 70-90% of the cost of a
project. [1]Lenders rely on the future cash flow projected to be generated by the project for
interest and debt repayment rather than value of its assets. The main security for lenders is the
project company’s contracts, ownership rights to natural resources. There are no guarantees
from the investors in the project company (recourse finance) or only limited guarantees for the
project finance debt.

Fig: Model of Project Finance [4]

Prepared By: Associate Prof. Ishwar Adhikari/Department of Civil Engineering/Kathmandu Engineering
College (Affiliated to Tribhuvan University), Kathmandu, Nepal.
6.2 DIFFERENCE BETWEEN CONVENTIONAL AND PROJECT
FINANCING
CONVENTIONAL FINANCING PROJECT FINANCING
 A creditor makes an assessment of  Cash flow from the project related
repayment of his loan by looking all assets alone are considered for
the cash flows and resources of the assessing the repaying capacity.
borrower.
 End use of the borrowed funds is not  The creditors ensure proper
strictly monitored by the lenders utilization of funds and creation of
assets as envisaged in the project
proposal.
 The creditors are not interested in  Project financiers are keen to watch
monitoring the performance of the the performance of the enterprise
enterprise and they are interested and suggest/take remedial measures
only in their money getting repaid in as and when required to ensure that
one way or the other project repays the debt out of its
cash generations.
Project finance is different from traditional finance because the credit risk associated with the
borrower is non-recourse. [5] Unlike the traditional borrowing method, where the borrower
bears the entire risk of repayment, in project finance, the borrower’s liability to repay is limited.
This is because the debt funding is non-recourse or limited recourse in nature. That being said,
the lenders cannot claim the personal assets of the project owner in case the latter defaults on
repayment or the project fails.

6.3 SOURCES OF PROJECT FINANCE

Prepared By: Associate Prof. Ishwar Adhikari/Department of Civil Engineering/Kathmandu Engineering

College (Affiliated to Tribhuvan University), Kathmandu, Nepal.
 1. Equity
Equity is simply the value of an investor's stake in a company. It is represented by the value
of shares an investor owns. Stock ownership gives shareholders access to potential capital
gains and dividends.

(a) Equity capital

It represents ownership capital as equity shareholders collectively own the company. They
enjoy the rewards and bear the risks of ownership.

(b) Preference capital

It represents hybrid form of financing: some characteristics of equity and some attributes
of debentures. [3]It resembles equity as preference dividend is payable only out of
distributable profits. It represents debentures as the dividend rate of preference capital is
usually fixed.
(c) Internal accruals
It consist of depreciation charges and retained earnings. It is non - cash charge and
considered an internal source of finance.
2. Debt
When a company borrows money to be paid back at a future date with interest it is known
as debt financing. Debt financing is essentially the act of raising capital by borrowing
money from a lender or a bank, to be repaid at a future date.

(a) Term Loan

A term loan provides borrowers with a lump sum of cash upfront in exchange for specific
borrowing terms. Borrowers agree to pay their lenders a fixed amount over a certain
repayment schedule with either a fixed or floating interest rate. [6]

(b) Debentures
A debenture is a bond issued without any collateral. It is also known as unsecured bond.
Thus, debenture holders are the general creditor of the company. A company having strong
credit position and highly profitable investment, and high amount of assets issue debenture.

(c) Bond
A bond is essentially a long-term note given to the lender by the borrower, stipulating the
terms of re-payment and other conditions.

6.4 CAPITAL BUDGETING

Capital budgeting is a process that businesses use to evaluate potential major projects or
investments. It may be defined as the firms' decision to invest its current funds most
efficiently in long term activities in anticipation of an expected flow of future benefit over
a series of years. The long term activities are those activities which affects firms' operations
beyond the one year period. Capital Budgeting consists in planning development of
available capital for the purpose of maximizing the long term profitability of the concern.
[7].
Prepared By: Associate Prof. Ishwar Adhikari/Department of Civil Engineering/Kathmandu Engineering
College (Affiliated to Tribhuvan University), Kathmandu, Nepal.
 FEATURES OF CAPITAL BUDGETING

1. The exchange of current funds for future benefit (i.e. funds are invested only for future
benefit)
2. Potentially large anticipated benefits.
3. A relatively high degree of risk.
4. The future benefits will occur to the firms over a series of years (i.e. funds are invested
only if future benefits occur over a series of years)
5. Relatively long time period between the initial outlay and the anticipated return.
6. They are irreversible decisions.
7. They are among the most difficult decision to make.
PROCESS OF CAPITAL BUDGETING
1. Project Generation
Any project needs a written material - proposal – to initiate dialogue on funding. So, project
generation is development of proposal for investment decision. The proposal may focus in
adding new equipment for increasing the rate of production, or it may focus to reduce the
cost of production. The healthy firm is one in which there is a continuous flow of profitable
investment proposals.

2. Project Evaluation
While evaluating a project, following point should be considered:
(a) Estimate on cash flow, which is difficult, as future is uncertain,
(b) Selection criteria to judge the project viability
(c) Estimated benefit over cost
Project evaluations is done by expert groups. It involves two steps:
(a) Estimation of benefit and costs, the benefits and costs must be measure in terms of cash
flow, and
(b) Selection of appropriate criterion to judge the viability of the project

3. Project Selection
The screening and selection procedure may vary from firm to firm. Since the capital
budgeting decisions are of considerable significance for several reasons, the final approval
of the project may generally rest on top management. However, projects are screened at
multiple levels. Sometimes the top management may delegate authority to approve certain
type of investment proposals.

4. Project Execution
After the final selection of the investment proposal, the funds are appropriated for capital
expenditure. The formal plan for appropriation of funds is called capital budget. Such plans
are prepared or approved by the project execution committee or the top management.
Prepared By: Associate Prof. Ishwar Adhikari/Department of Civil Engineering/Kathmandu Engineering
College (Affiliated to Tribhuvan University), Kathmandu, Nepal.
 INVESTMENT DECISION CRITERIA
A set of evaluation criteria should be used having following characteristics:
 It should provide a ranking of projects in order of their desirability (viability).
 It should also solve the problem of choosing among alternative projects.
 It should be a criterion which is acceptable to any conceivable investment project.
 It should recognize the fact that bigger benefit are preferable to smaller ones, and
early benefits are preferable to later benefits.
 It should provide a means of distinguishing between acceptable and unacceptable
projects
A. Traditional criteria
a. Payback period
i. Simple Payback period and
ii. Discounted payback period
b. Accounting rate of return (ARR)
B. Discounted Cash Flow (DCF) criteria
a. Net present value/Net future value /Net annual value
b. Internal Rate of Return (IRR)
c. Profitability index or B/C ratio

Payback Period Method

It is defined as the number of years required to recover the original cash outlay invested in a
project. If the project generates constant annual cash inflows, the pack back period can be
computed dividing cash outlay by the annual cash inflow. That is:
Payback period = Cash outlay (investment) / Annual cash inflow.
Simple payback does not considers time value of money where as discounted payback
considers time value of money.
Accounting Rate of Return (ARR) Method
This method is based on conventional accounting concept. The rate of return is expressed as
the percentage of the earnings of the investment in a particular project. [8] ARR is obtained by
dividing the average income after taxes by the average investment
ARR = Average Income/Average Investment
Average income = (income – expenses – taxes)/ number of years
Average investment = (Original investment + salvage or scrap value)/2

Prepared By: Associate Prof. Ishwar Adhikari/Department of Civil Engineering/Kathmandu Engineering

College (Affiliated to Tribhuvan University), Kathmandu, Nepal.
Net Present Value (NPV) Method
It is one of the discounted cash flow techniques. It recognizes the time value of the money. In
this method, first, the present value of the cash inflow and the present value of cash out flow
are computed separately. NPV is the difference between these two present values.
NPV = PV of cash inflow – PV of cash out flow
If the result is positive, the project is accepted and if the result is negative, the project is
rejected.
Internal Rate of Return (IRR)
The Internal Rate of Return can be defined as that rate which equates the present value of cash
inflow with the present value of cash outflow of an investment. In other words, it is that rate at
which the Net Present Value (NPV) is zero. Accept, if IRR is more than normal bank rate or
investors' rate (IRR≥MARR) and reject, if IRR is less than normal bank rate or investors' rate.
(IRR≤MARR)
Profitability Index or Benefit Cost (B/C) ratio
Profitability index (or B/C ratio) is the ratio of the present value of the future cash inflow at the
required rate of return to the present value of cash outflow.
Profitability index (or B/C ratio) = (PV of future cash inflow) / (PV of investment).
Accept, if PI or B/C ratio is more than one (BCR ≥1) and reject, if PI or B/C ratio is less than
one (BCR ≤1)
EXAMPLE OF ARR
A project costs $ 50,000 and has a scrap value of $ 10,000. Its stream of income before
depreciation and taxes during first year through five years is $ 10,000, $ 12,000, $ 14000,
$16000 and $ 20,000. Assume 50% tax rate depreciation on straight line basis. Calculate ARR
of the project.
Initial investment = $ 50,000, Scrap value = $ 10000
Total depreciation = $ 50,000 - $ 10000 = $ 40,000
Number of Year = 5 years.
Depreciation per year = 40000/5 = $ 8000

Year 1 Year 2 Year 3 Year 4 Year 5

(a)Income ($) 10,000 12,000 14,000 16,000 20,000
(b)Depreciation ($) 8,000 8,000 8,000 8,000 10,000
(c)Gross income (a-b) ($) 2,000 4,000 6,000 8,000 5,000
(d)Tax (50%) ($) 1,000 2,000 3,000 4,000 5,000
(e)Net income ($) 1,000 2,000 3,000 4,000 5,000
Average income = (1000+2000+3000+4000+5000) / 5 = $ 3200

Prepared By: Associate Prof. Ishwar Adhikari/Department of Civil Engineering/Kathmandu Engineering

College (Affiliated to Tribhuvan University), Kathmandu, Nepal.
 Average Investment = (50000+10000)/2 = 30000
ARR = Avg. Income /Avg. Investment = 3200/30000 = 10.67%

6.5 CAPITAL STRUCTURE PLANNING

Capital structure, sometime known as financial plan (Capital plan or financial plan) refers to
the composition (makeup) of long-term sources of funds, such as debentures, long-term debt,
preference share capital, and equity share capital including reserve and surplus. [9]It helps the
company in increasing its profits in the form of higher returns to stakeholders. A proper capital
structure helps in maximising shareholder's capital while minimising the overall cost of the
capital. With unplanned capital structure, organization may also fail to economies the use of
their funds.
FEATURES OF CAPITAL STRUCTURE
1. Profitability
The capital structure of the company should be most advantageous. Within the constraints,
maximum use of leverage (influence on ESP caused by debt or preference share capital, and
equity share) at a minimum cost should be made.
2. Solvency
The use of excessive debt threatens the solvency of the company. Debt should be added only
point up to a level which does not added substantial risk to the company.
3. Flexibility
Flexibility means the firm's ability to decide on its capital structure to meet its dynamic need.
The company's capital structure should be flexible enough to meet the dynamic need of the
company.
4. Conservation
Conservatism deals with cash flow ability of the company. The capital structure of a firm
should also be conservative in the sense that the debt capacity of the company should not be
exceeded.
5. Control:
The capital structure should involve minimum risk of loss of control of the company. In other
word, capital structure should be planned in such a way that the company should always be
able to keep control on it.
IMPORTANCE OF CAPITAL STRUCTURE
1. Value Maximization
In a firm having a properly designed capital structure the aggregate value of the claims and
ownership interests of the shareholders are maximized.
2. Cost Minimization
Prepared By: Associate Prof. Ishwar Adhikari/Department of Civil Engineering/Kathmandu Engineering
College (Affiliated to Tribhuvan University), Kathmandu, Nepal.
Capital structure minimizes the firm’s cost of capital or cost of financing. By determining a
proper mix of fund sources, a firm can keep the overall cost of capital to the lowest.
3. Increase in Share Price
Capital structure maximizes the company’s market price of share by increasing earnings per
share of the ordinary shareholders. It also increases dividend receipt of the shareholders.
4. Investment Opportunity
Capital structure increases the ability of the company to find new wealth- creating investment
opportunities.
5. Growth of the Country
Capital structure increases the country’s rate of investment and growth by increasing the firm’s
opportunity to engage in future wealth-creating investments.

NUMERICAL
A firm has total capital of $ 10, 00,000 which consists of 3000 ordinary share @ $ 100 per
share, $ 200,000 preference share at 10% interest per year and $ 5, 00,000 debts at 12% interest
per year. If firm’s earnings before interest and tax are $ 2, 50,000 and tax rate applicable is
30%, determine earning per share.
• Ordinary share = 3000@ $ 100
• Preference share = 2, 00,000 @10% per year
• Debt Capital = 5, 00,000 @ 12% per year
• Firm’s earnings before interest and tax (EBIT) = 2,50,000
• Interest on loan = 12% of $ 5,00,000 = 60,000
• Earnings after interest before tax (EAIBT) = (a-b) = 1,90,000
• Tax @ 30% of EAIBT = 57,000
• Earning after interest and tax (EAIT) = 133,000
• Interest (dividend) to preference shareholders = 10% of 2,00,000
= 20,000
• Dividends to ordinary shareholders = (e-f) = 1,13,000
• Earnings per share (EPS) = 1,13,000 / 3,000 = 37.67
Book Value = Original value + EPS = 100+37.67 =137.67

Prepared By: Associate Prof. Ishwar Adhikari/Department of Civil Engineering/Kathmandu Engineering

College (Affiliated to Tribhuvan University), Kathmandu, Nepal.
REFERENCES:
[1] Principles of Project Finance: E. R. Yescombe, Yescombee Consulting Ltd. Academic
Press, 2002.
[2] Project Management: K. Nagarajan, New Age International (P) Ltd. Publishers, New
Delhi, India, 2001.
[3] Projects; Planning, Analysis, Financing, Implementation and Review: Prasanna Chandra,
Fifth Edition, Tata McGraw – Hill Publishing Company Limited, New Delhi, India, 2002.
[4] [Link]
[5] [Link]/blog/what-is-project-finance-and-how-project-financing-
works
[6] [Link]/terms/t/[Link]
[7] [Link]/sagar_sjpuc/capital-budgeting-presentation
[8] [Link]/capital-budgeting-presentation
[9] Modern Project Management: R.C. Mishra and Tarun Soota, First Edition, ISBN: 81-224-
1616-0, New Age International (P) Ltd., New Delhi, India, 2005.)
[10] [Link]
[11] [Link]/financial-management/capital-structure/capital-structure-
concept-definition-and-importance

Prepared By: Associate Prof. Ishwar Adhikari/Department of Civil Engineering/Kathmandu Engineering

College (Affiliated to Tribhuvan University), Kathmandu, Nepal.