Modes of Project Financing

PROJECT FINANCING,
PLANNING, & EVALUATION
By
Khalid Jamil Ansari
WHY PREFERRENCE IS GIVEN
TO PROJECT FINANCING?
2
What are the different sources
of project financing available?
3
Questions
• What sources has your company raised
capital from in order to finance projects?
• Why were these sources used?
• In what form was the finance provided

(loans, grants, other… )?
• Were any possible sources considered

but not used?
4
Potential sources of project financing
A. Internal funds
B. Private sector:
1. commercial banks
2. development corporations
3. equipment vendors/ subsidiary finance companies
4. owners’ capital (“equity”)
C. Governmental sector:
grants/ earmarked capital from
governmental programmes
5
Investing and financing decisions
• Distinguish between:
– The investing decision
– The financing decision
• Investing decision: is the project acceptable? (i.e.

does it have a positive NPV, at the relevant
discount rate?)
• Financing decision: what is the best (usually, the
cheapest) way to fund it?
6
Internal funds and the financing decision
• Internal funds are generated from past cash flows

• Internal funds (if available) are usually the best
source, but…
• They have an opportunity cost - what else could be
done with these funds? (e.g. finance other projects,
invest in financial securities, etc.)
• “Soft” funds specifically for CP projects may be
preferable to internal funds
7
The variety of securities for Financing Companies
• International firms use different kinds of

securities:
– Stocks and shares
– Long-term debt (secured or unsecured by mortgages
on plant and equipment);
– Short-term debt
– Lease or rent on long term basis
• Why are these securities not all relevant to

small and medium-sized companies?
8
Commercial banks
• Banks are businesses that offer a variety
of options to other organisations to finance
their investments. The most frequent
options are:
1. Loans to finance the purchase of fixed assets (land
and/or equipment)
2. Lines of credit (debt provided by the bank without
conditions on how the borrower must use those
funds)
9
Development Corporations
• Development corporations/banks are
established to contribute to the economic
development of a particular community or
region
• Projects which comply with their criteria
can apply for loans
• Question: what development
corporations/banks are you aware of?
10
Equipment vendors and Subsidiary finance companies
• Leasing has become a major source of

financing that is provided by some equipment
vendors and subsidiary finance companies
(‘lease-providers’).
• With ‘financial leases’ (or ‘capital leases’):

– Title to the equipment is held by the firm
which operates it (the ‘lease-holder’)
– The lease-provider retains a first security
interest in the equipment
– The lease-holder faces the risks and
receives the rewards of ownership
11
Owners’ capital (equity)
• Represented by ordinary shares in a company (or
‘stock’)
• Can be raised from either/both
– Present owners (shareholders)
– New shareholders
• But:
– Present owners may not have spare capital available
– Bringing in new shareholders may dilute the
shareholdings of present shareholders
• Issues of new shares in a company can be by:
– A public issue
– A private placement of stock
12
Share issues
• Public issues of stock:
– For larger companies
– Requires a stock market listing
– Substantial administrative costs
– Not usually suitable for single projects
• Private placements of stock:
– Stock is bought by private persons but not on
a public market
– Still significant administrative costs
13
Financing projects:
Summary (1)
• Keep the financing decision distinct from the
capital budgeting decision
• Identify the pool of funds available to your

company
• Map the rates and terms of payment of different

possible sources (differences may be huge!)
• Try to establish long-term relationships with

potential sources of finance
14
Financing projects:
Summary (2)
• The main factors are:

– How much capital is available in the country
– The characteristics of projects
• Important characteristics of each
application include:
– The level of uncertainty of future cash flows
– The duration of the project (long or short term)
15
Financing projects:
Summary (3)
• Each source of capital has its own
mechanisms which the company has to
manage:
– The application process
– The criteria of the fund provider
– The terms of repayment
– Any other restrictions put on the company (e.g.
a maximum ratio of debt to equity, to limit risk)
16
What information is a
bank likely to want?
17
Question
• If your company were to apply to a bank
for a loan to finance a project:
– What information is the bank likely to require

from you?
– Is there any further information that you could

provide to support your application?
18
Typical information to evidence a
company’s
credit-worthiness (1)
• Historical financial statements for the

past three years (balance sheet, income
statement)
• Projected financial statements for the

next 1-3 years (balance sheet, income
statement, cash flow forecast)
19
Balance Sheet (in Rs.’000)
Capital & liabilities Assets
Share capital 60 Equipment 73

Retained 42 Inventory 21
profits
Accounts 29
Accounts 23 receivable
payable ____
Cash 2
125
___
125
20
Income Statement
(in Rs.’000)
Sales revenue 203
less: Cost of goods sold - 156
= GROSS PROFIT 47
less: Overhead (indirect) costs - 35
e.g. staff costs, rent, etc.
= NET PROFIT 12
21
Typical information to evidence a company’s
credit-worthiness (2)
• For sole traders and partnerships:
personal financial statements and/or tax
returns of the owner(s)
• Bank and credit references; payment

histories on other loans or leases
• Additional background information on the

business
22
Presenting a fund application
Companies want to implement its 3-stage project. For
example the project requires an initial investment of
Rs.18 million; but company has only Rs.2 million in
cash, which it needs for day-to-day operations. It
therefore needs to seek external finance. Three
potential sources have been identified:
– a commercial bank
– a development bank
– Direct lending / Public Offerings
23
Presenting a fund application:
Commercial bank
An application to a commercial bank should

focus on:
– The increase in efficiency achievable by the
investment
– The firm’s increased flexibility to respond swiftly

to future changes in environmental regulation
– Ensuring the firm’s competitiveness
– Return on investment 24
Presenting a fund application: Development bank
• An application to a development bank

should focus on:
– The company is small and has difficulties in obtaining
funds through conventional channels
– Explain that the company is also applying for a

matching grant, e.g. from a government programme
– Potential growth of the company due to increased

cash flows from the investment
– The firm’s fiscal stability and ability to repay the loan

25
Presenting a fund application:
Government environmental programme
• An application to a government programme

should focus on:
– The potential use of the project as a
demonstration project
– The potential environmental improvement from

the project
– The company’s intention to match the grant by

also raising a loan
26
Summary
• Gather information on the past lending
practices of each potential funding source
(to gain insight into their motivations)
• Consider the motivation of the funding

source when preparing an application
• Anticipate the information needs for the

sources of capital
27
Investment projects
• Investment projects and company value
• Discussion of experiences with

investment projects
• Typical project types & goals
28
Capital budgeting —
Introduction
• Capital budgeting definition and main
implementation steps
29
Capital budgeting —
Profitability assessment
• Estimating project profitability with Net

Present Value (NPV)
– Time value of money & discounting
• Alternative profitability indicators

– NPV, IRR, Payback
30
Project financing
• Project financing sources
– Discussion of course participant experiences with
project financing
– Types of investment and financing decisions
– Different types of funding sources
• Bank information requirements

– How to demonstrate credit-worthiness
– Case study and small group exercise on bank
information requirements
31
Cost/Benefit Analysis
When benefits and costs are

measured on the same scale,
such as dollars, the benefits
should exceed the costs for a
given course of action.
When benefits can not be

measured readily in dollars, cost-
benefit analysis generally requires
the comparison of two or more
alternatives.
When the alternatives are estimated

to provide the same benefit (such as
the same level of national defense),
the alternative with the lowest cost
should be selected.
Benefit Measurement Methods
Comparative Approaches
Scoring Models
Benefit Contribution
Economic Models
Scoring Models
Economic Models
Scoring Models
Economic Models
Scoring Models
Economic Models
Scoring Models
Economic Models
The process of identifying the financial (economic)

benefits is called
Capital Budgeting.
It is the decision-making process by which some
organizations evaluate and select projects.
Sophisticated capital budgeting techniques

take into consideration depreciation
schedules, tax information, inflation and
other economic considerations.
Since we are discussing only the

principles of capital budgeting we
will restrict our discussion to:
• Benefit/Cost Ratio
• Payback Period
• Discounted Cash Flow
– Net Present Value
• Internal Rate of Return (IRR)
• Payback Period
• Net Present Value
Simply put it is the financial value of the benefit
divided by the financial cost.
$Benefit
$Cost
Benefit Measurement
Methods
Project Benefit = $ 7,000

Project Cost = $ 5,000
Benefit/Cost Ratio = 1.4
• Benefit/Cost Ratio (Criteria)

An organization could establish any “criteria”
that they wanted for the purposes of
evaluating a project. Company A might have
a Benefit/Cost Ratio requirement of 1.5 or
greater. Company B might simply make the
decision to do the project if it had a
Benefit/Cost Ratio of 1.0.
• Payback Period
• Payback Period
Payback period is the length of

time, usually expressed in years or
fractions there of, needed for a firm
to recover its initial investment on a
project.
• Payback Period
Initial Project Expense = $5,000
Payback
Year 1 $1,000 ($4,000)
Year 2 $2,000 ($2,000)
Year 3 $2,000 $0
Year 4 $2,000 $2,000
• Payback Period (Criteria)

An organization that uses Payback
Period would also have to define what
the payback period criteria would be.
Some organizations would be very
happy with a payback period of three
years. Others would no doubt use a
much shorter payback period criteria.
• Benefit/Cost Ratio & Payback Period
These two approaches have a common

problem. They do not take into consideration
the
“TIME VALUE OF MONEY”.

As a result they are typically used on only
relatively short term projects.
Future Value
And
Present Value
Concepts
• Future Value
FV = PV (1+interest rate)
raised to the (number of years)
power.
• Future Value
Lets say we have $1,000 invested at 6% for
three years.
FV = $1,000 (1+.06) to the third power.
FV = $1,000 * (1.1910)
FV = $1,191
• Future Value Table

Years 2% 3% 6% 10%
1 1.0200 1.0300 1.0600 1.1000
2 1.0404 1.0609 1.1236 1.2100
3 1.0612 1.0927 1.1910 1.3310
4 1.0824 1.1255 1.2624 1.4641
5 1.1040 1.1592 1.3382 1.6105

• Present Value
PV = FV * 1 / ((1+interest rate) to the

(number of years) power).
• Present Value
The result of discounting one or more

amounts to be received or paid in the
future by a discount rate.
• Present Value
For example:
$100 invested at 6% will amount to
$106 at the end of one year (this is
a future value).
Therefore:
• Present Value
The present value of $106 due at the

end of one year at 6% is $100.
• Present Value
Lets say we have $1,000 being sent to us
3years from now and the inflation rate is at 3%.
PV = $1,000 * 1/((1+.03) to the third power).
PV = $1,000 * (.9151)
FV = $915.10
• Present Value Table

Years 2% 3% 6% 10%
1 .9803 .9708 .9433 .9090
2 .9611 .9425 .8899 .8264
3 .9422 .9151 .8396 .7513
4 .9238 .8884 .7921 .6830
5 .9057 .8626 .7472 .6209

• Present Value Analysis

Any method of evaluating alternatives with the
time value of money incorporated to more
effectively determine the long term financial
effects on investment dollars.
(It is the recognition that any amount due in
the future is worth less than that same amount
if it were due today.)
• Payback Period

1. A method of evaluating a long term project
that explicitly takes into account the time
value of money.
2. The present value of all expected net cash
receipts from a project, discounted by an
appropriate discount rate.
(Payback) Discounted Cash Flow at 6%.
Future Present
Value Value
Year 1 $1,000 $ 943 ($4,057)
Year 2 $2,000 $1,780 ($2,277)
Year 3 $2,000 $1,697 ($ 580)
Year 4 $2,000 $1,584 $1,004

Payback
Year 1 $1,000 ($4,000)
Year 2 $2,000 ($2,000)
Year 3 $2,000 $0
Year 4 $2,000 $2,000
• Payback Period

The algebraic sum of the present values of all
outlays and inflows associated with a given
project or investment. Calculation of net
present value usually involves subtracting
the initial outlay cost of an investment from
the present value of all future cash flows.
Discounted Cash Flow at 6%.
Year 1 $1,000 $ 943
Year 2 $2,000 $1,780
Year 3 $2,000 $1,697
Year 4 $2,000 $1,584
Total $6,004 accrued benefit
Less Investment - 5,000
Net Present Value $1,004
• Payback Period
The effective annual

Return on Investment (ROI)
over the life of a project.
IF we invested $5,000 in a project,

and we got a $6,004 discounted
return on the investment, WHAT
interest rate would we have had to
have received on an investment of
$5,000 to get that $6,004?

$6,004 / $5000 = 1.2008 (a factor)
Years 2% 3% 6% 10%
1 1.0200 1.0300 1.0600 1.1000
2 1.0404 1.0609 1.1236 1.2100
3 1.0612 1.0927 1.1910 1.3310
4 1.0824 1.1255 1.2624 1.4641

5 1.1040 1.1592 1.3382 1.6105
We are looking for a factor of 1.2008

Is it 5% ?
No, 5% for 4 years = 1.2155
Is it 4.5% ?
No, 4.5% for 4 years = 1.1925
Is it 4.7% ?
Very close, 4.7% = 1.2016
• Internal Rate of Return (Criteria)
Hurdle Rate
The minimum acceptable
return on investment.
• Internal Rate of Return (Criteria)
Hurdle Rates
High Tech Companies tend to very
high “hurdle rates”.
Less competitive organizations
tend to have much lower “hurdle
rates”.
• Payback Period
–Net Present Value

Net Present Value (NPV)
= net amount of discounted future

cash flows less initial investment
 reflects amount (in $) added by
project to total company value
 recognizes time value of money
 complex to calculate
 needs prior estimate of cost of
raising capital
79
Internal Rate of Return (IRR)
= discount rate at which NPV = 0
 basis to compare with costs of

different sources of finance
 recognises time value of money
 complex to calculate
 does not directly reflect impact
on value
80
Payback
= time needed for net cash inflows to equal the initial
investment
 simple to calculate and understand
 reflects risk of project life being shorter than
expected
 ignores all cash flows after payback point
 simple version completely ignores time value of
money
81

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Modes of Project Financing

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PROJECT FINANCING,

PLANNING, & EVALUATION

• Why were these sources used?

• In what form was the finance provided

• Were any possible sources considered

• Investing decision: is the project acceptable? (i.e.

• Internal funds are generated from past cash flows

• International firms use different kinds of

• Why are these securities not all relevant to

• Leasing has become a major source of

• With ‘financial leases’ (or ‘capital leases’):

• Identify the pool of funds available to your

• Map the rates and terms of payment of different

• Try to establish long-term relationships with

• The main factors are:

– What information is the bank likely to require

– Is there any further information that you could

• Historical financial statements for the

• Projected financial statements for the

Share capital 60 Equipment 73

• Bank and credit references; payment

• Additional background information on the

An application to a commercial bank should

– The firm’s increased flexibility to respond swiftly

– Ensuring the firm’s competitiveness

• An application to a development bank

– Explain that the company is also applying for a

– Potential growth of the company due to increased

– The firm’s fiscal stability and ability to repay the loan

• An application to a government programme

– The potential environmental improvement from

– The company’s intention to match the grant by

• Consider the motivation of the funding

• Anticipate the information needs for the

• Investment projects and company value

• Discussion of experiences with

• Typical project types & goals

• Estimating project profitability with Net

• Alternative profitability indicators

• Bank information requirements

When benefits and costs are

When benefits can not be

When the alternatives are estimated

The process of identifying the financial (economic)

Sophisticated capital budgeting techniques

Since we are discussing only the

Project Benefit = $ 7,000

• Benefit/Cost Ratio (Criteria)

Payback period is the length of

• Payback Period (Criteria)

• Benefit/Cost Ratio & Payback Period

These two approaches have a common

“TIME VALUE OF MONEY”.

• Future Value Table

2 1.0404 1.0609 1.1236 1.2100

3 1.0612 1.0927 1.1910 1.3310

4 1.0824 1.1255 1.2624 1.4641

5 1.1040 1.1592 1.3382 1.6105

PV = FV * 1 / ((1+interest rate) to the

The result of discounting one or more

The present value of $106 due at the

• Present Value Table

2 .9611 .9425 .8899 .8264