CHAPTER -7 PROJECT FINANCING

7.4.1. OVERVIEW
The allocation of financial resources to a project constitutes an obvious and basic prerequisite
for investment decisions, for project formulation and pre-investment analysis,.The major sources
of finance available to a firm are shareholders and lenders. Capital structure means the
proportion of debt and equity financing in a given firm. Key Business Considerations in Planning
the Capital Structure of a Firm:
 Earnings Per Share (EPS)
 Risk (business risk & financial risk)
 Control
 Flexibility
 Nature of Assets
1. EQUITY
General financing pattern for an industrial project: Cover the initial capital investment by equity
and long-term loans to varying extent. Finance the minimum net working capital requirement
using long-term capital. Meet subsequent WC requirements by additional short-term & medium-
term loans from banks. In situations where institutional capital is scarce & available only at high
cost, equity capital covers the initial capital investment and net working capital.
Maintain appropriate balance between long-term debt and equity. The higher the proportion of
equity, the lesser will be the debt service obligations and hence, the higher the gross profit before
tax (EBT). Whereas the higher the proportion of loan finance, the higher the interest payable on
liabilities will be and hence, the lesser the gross profit before tax (EBT). Carefully assess the
implications of alternative patterns & forms of financing in every project. Determine a financing
pattern that is consistent with both availability of resources & overall economic returns.
2. LOAN FINANCING
_ Financial institutions and commercial banks provide loans that represent recurrent borrowings.
_ Loans are very important sources for financing:
– New projects, Expansion & modernization projects, Replacement investments, It is relatively
easy for a sound project to obtain loans.,
Process of project financing may start by identifying:
 The extent to which loan capital can be secured.
 The interest rate applicable to the loan.
Sources of loan funds
_ (A) Short-term & medium-term borrowings from commercial banks for WC financing or
suppliers’ credit for purchases of materials and inputs.
_(B) Long-term borrowings from national or international development finance institutions for
making investment in fixed assets.
 Loan financing is usually subject to certain restrictions vis-à-vis raising additional debt
funds, convertibility into shares, declaration of dividends, etc.
 Certain ratios in the capital structure of the company need to be maintained.
 Investments may also be financed partly by issues of bonds & debentures.
 An important source of finance is also available at government-to-government level in
developing countries.
 This can be a bilateral credit or tied credit, which may be related to the purchase of
machinery & equipment from particular country or source.
– Identify the pattern of advancing the funds obtained from loan sources. Enter into loan contract
with [Link] loan contract will be the basis for loan repayment schedule input for the
financial plan.
Contract terms on the Loan:
 Amount of loan & currency involved (local/foreign)
 Interest rate (amount, frequency of compounding, etc)
 Grace period
 Loan amortization/repayment arrangements (amount of installment payments, maturity
date, etc)
 Collateral requirements
 The contract should explicitly state the arrangements for periodically drawing the loan
funds based on some condition (e.g., % of project completion, etc).
_(C) Denture Capital
Debentures (such as bonds, mortgages, etc) issued to the public to raise additional long-term
funds. Debentures are important instruments for raising debt capital. Similar to promissory notes.
can be convertible (wholly or partly) into equity shares. There are non-convertible debentures as
well. Straight debt instruments carrying fixed rate of interest and have a maturity period.
3. Supplier credits (deferred credits)
_ Suppliers of plant & machinery provides deferred credits. Payment made over a period of time
(not immediately). Suppliers of machineries in developed countries are willing to sell on
deferred-payment terms to buyers in the developing nations. Significant proportion of imported
machineries & spares often are financed on deferred credit terms (payments may spread over 6 to
10 years).
4. Leasing
Instead of borrowing, it is sometimes possible to lease plant equipment or even complete
production units. Productive assets could be borrowed on a long-term basis – through a lease
contract. Represents a contractual arrangement.
 The lessor grants the lessee the right to use an asset in return for periodic
lease rental payments.
 Usually requires an initial down payment and periodic payments (often
annual rents) – lease fee.
 Leasing of land & building has been known a long ago. But the leasing of
industrial equipment is a relatively recent phenomenon (for instance, in
Ethiopia).
  Types of Lease: Finance Lease and Operating Lease.
(A) Finance Lease (or Capital Lease)
It is essentially a form of borrowing. Salient features of Finance Lease:
 It is an intermediate term to a long-term noncancelable arrangement.
 The lease cannot be cancelled during the initial lease period.
Referred to as the “primary lease period”. Usually 3 years, 5 years, or 8 years.
The lease is more or less fully amortized during the primary lease period. During this period, the
lessor recovers (through the lease rentals) his/her investment in the equipment along with an
acceptable rate of return. A finance lease transfers substantially all the risks and rewards incident
to ownership to the lessee. The lessee is responsible for maintenance, insurance, and [Link]
lessee usually enjoys the option for renewing the lease for further periods at reduced lease
rentals.
(B) Operating Lease
 Defined as any lease other than a finance lease. Salient features of an Operating Lease:
 The lease term is significantly less than the economic life of the equipment being leased.
 The lessee enjoys the right to terminate the lease at a short notice without any significant
penalty.
 The lessor usually provides the operating know-how & the related services and
undertakes the responsibility of insuring & maintaining the equipment. Such an operating
lease is called a “wet lease".
 An operating lease where the lessee bears the costs of insuring & maintaining the leased
equipment is called a “dry lease".
An operating lease does not result in a substantial transfer of the risks and rewards of ownership
from the lessor to the lessee. The lessor has to depend upon multiple leases or on the realization
of a substantial resale value (on expiry of the first lease) to recover the investment cost plus a
reasonable rate of return. Specializing in operating lease calls for an in-depth knowledge of the
equipment and the secondary (resale) market for such equipments. The prerequisite for popularly
using operating leases is the existence of a resale market. Assets acquired through lease contracts
are contained in the balance sheets of the lessors and not in the lessees And The lessee cannot
claim depreciation on the leased assets. (the lessee is not the owner of the asset). The lessee
charges the periodic lease payments as a tax-deductible expense and does not enjoy the asset’s
salvage value.
Leasing is an off-balance sheet financing to the lessee.
Basic concern of financial managers: to choose the best option (leasing or purchasing of capital
assets). Discounted cash flow technique should be applied to evaluate such alternatives and
Cash outflows (i.e., investment cost) of the project constitutes the initial down payment, current
leasing fees, and subsequent payments under the lease agreement. But duration of lease contracts
often is shorter than the technical (or economic) life of the leased assets.
How should the residual value of the leased assets treated for the sake of financial appraisal?
When comparing leasing with other alternatives such as loan financing (equivalent loan/buy the
asset by borrowing), the residual/resale value of the asset should be included as an inflow in the
latter. The amount that is considered an inflow for the borrow & purchase option would usually
not be the book value.
It should be the lower of either the BV or the MV (minus the lessors cost of selling the used
items).
5. INCENTIVES
_ Government units or agencies may provide financial support in various forms:
 Seed capital assistance provided at nominal rate of interest in order to enable the
promoters meet their contribution to the project.
 Capital subsidy provided by regional or local governments in order to attract industries to
certain locations (less developed, backward, or marginalized areas).
 Provisions for deferring payment of taxes, partial or full exemption of taxes for a certain
period (such as sales tax), etc.
7.4.4. COST OF CAPITAL
 Equity and long-term loans often are used to cover the initial capital investment. Short-
term & medium-term loans are used to meet additional WC requirements in later
years/periods. Loans are very important sources for financing various forms of
investments/projects.
 Lending: Long-term, medium-term, or short-term commitment for transferring surplus
funds to the deficit spending (or borrowing) units.
o Reduces the liquidity of the lender.

o Increases risk due to uncertainties concerning the full return of the funds lent.

 Lenders need a reward as a compensation for:

 Risk assumed
 Time value of money
 Opportunities foregone
_ Equity investors (owners) also provide substantial amount of funds for a firm with the
expectation of a return that compensates:
  Business & financial risks assumed
 Implied costs arising from the sacrifice of alternative investment opportunities.
 We cannot finance projects using equity funds alone, nor is it necessary.
 Many lenders provide long-term loans for sound projects at optimum prices.
 A balance needs to be maintained between long term debt & equity financing.
 These are external sources of funds.
 A firm must pay reasonable prices to suppliers to raise (or obtain) such funds.
 This price is referred to as the cost of capital or cost of funds.
 Cost of capital comprises:
 Interest charges on borrowed funds (usually expressed as a % per annum)
 Certain fixed charges (such as commitment fee, charge on capital not drawn,
commissions, etc)
 Periodic dividends to the shareholders (paid on the basis of outstanding shares of the
firm)
 Interests are usually computed on the outstanding balance of the corresponding liabilities.
 Dividend payments depend on the level of income generated from current operations (it
is paid as per the decisions of the firm’s board of directors).
 Carefully assess the implications of alternative patterns and forms of financing.
 Determine the financing pattern that is consistent with both the availability of resources
and overall economic returns.
 The tax implications of debt financing should be considered in the process of determining
the optimum capital structure.
 Interest is a tax deductibility expense.
 The tax deductibility of interest reduces the effective cost of debt.
Determine the Weighted Average Cost of Capital (WACC) in light of the proposed proportion of
long-term financing and specific costs of each source. The WACC is the discount rate used in
discounting the future cash flows of the project. Considering debt and equity sources of external
finance, we can use the following formula:
WACC = (D% x Kd) + (E% x Kre)
where:
D% = proportion of funds raised from a specific debt source
Kd = after tax (or net) cost of specific source of debt
E% = proportion of funds raised from equity source
Kre = specific cost of equity funds
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