The Financing Decision

9 December 2021 1
 Financing Decisions (Cont…)
• The most important sources available to
corporations are:
– Equity financing
– Preference shares
– Loan stocks (debentures)
– Convertible loan stocks
– Term loans
– Leases
– Grants

9 December 2021 2
The Cost of Capital
and Capital
Structure
 The Cost of Capital
• The rate of return required by investors
supplying funds to a company.
– It is, thus, the minimum rate of return
required on prospective projects

9 December 2021 4
 Cost of Capital...
• Is an application that uses what we learned
in Risk/Return
• May be used as a discount rate or a hurdle
rate for evaluating some potential projects in
Capital Budgeting
• Can be used as the discount rate in finding
the value of the firm
• Can be used in a firm’s Shareholder Value-
Based Management system (MVA)
• May be affected by a firm’s financial policies

9 December 2021
 Weighted Average Cost of Capital
Weights

N
R   wi Ri Rates

• where: i 1

– wi is the target proportion of capital from funding

source i.
• This can be the existing market value proportions
if the firm is currently optimally levered.
– Ri is the incremental cost to the firm of using funding
source i.
• So, this formula is comprised of weights and rates.
• Capital funding sources include debt, common stock,
and preferred stock.
9 December 2021
 Calculating the Cost of
Individual Sources of Finance
• The first step in calculating a
company’s weighted cost of capital
(WACC) is to calculate the cost of the
individual components of its capital:
– Equity capital
– Preference shares
– Debt

9 December 2021 7
 Cost of Equity Capital
• The cost of equity is the rate of return
required by the suppliers of equity
finance.

• Equity finance can be raised either

through issuing new securities or
through the utilization of retained
earnings

9 December 2021 8
 The Cost of Equity (Cont..)
• To find the cost of equity (Ke) we can
adapt the Gordon growth model:

D0 1  g 
Ke  g
P0
• Where:
Ke = Cost of equity
P0 = ex-dividend share price
g = expected annual increase in dividends
D0 = dividend to be paid shortly
9 December 2021 9
 The Cost of Equity (Cont..)
• An alternative and arguably more reliable
method of calculating the cost of equity finance
is to use the CAPM.
• This model allows investors to work out their
required return on the equity finance of a
company, based on the rate of return earned on
risk-free investments plus a risk premium.
– Remember that the risk premium reflects both the
systematic risk of the company and the excess
generated by the market relative to the risk-free rate

9 December 2021 10
 The Cost of Equity - CAPM
• Using the CAPM the cost of equity
finance is given by the following linear
relationship
Rj = Rf + ßj (Rm - Rf)
Where:
Rj = the rate of return of security j predicted
by the model
Rf = the risk-free rate of return
ßj = the “beta” coefficient of security j
Rm = the return of the market
9 December 2021 11
The Cost of Preference Shares
• Calculating the cost of a company’s
preference shares is considerably easier than
calculating the cost of ordinary equity
because:
– Dividends paid on preference shares are usually
stable;
– Preference shares are, generally speaking,
irredeemable;
– Since preference dividends are a distribution of
after-tax profits, they are not tax deductible.

9 December 2021 12
 The Cost of Preference Shares (Cont..)
The cost of irredeemable preference shares (Kps)
can be calculated from the ex-dividend market price
and the dividend payable using the following model
Dividend payable
K ps 
Market value  ex  dividend 

If calculating the cost of raising new preference

shares, the above equation can be modified, as can
the Gordon model, to take into account issue costs

9 December 2021 13
 The Cost of Preference Shares
(Cont..)

The cost of irredeemable preference shares (Kps)

can be calculated from the ex-dividend market price
and the dividend payable using the following model
Dividend payable
K ps 
Market value  ex  dividend 

If calculating the cost of raising new preference

shares, the above equation can be modified, as can
the Gordon model, to take into account issue costs
9 December 2021 14
 The Cost of Debt
• The cost of debt is the rate of return
required by the suppliers of debt finance.
• There are two major types of securitized
debt:
– Irredeemable bonds; and
– Redeemable bonds
• The cost of irredeemable bonds is
calculated in a similar manner to that of
irredeemable preference shares.
– In both cases, the model being used is one that
values a perpetual stream of cash flows.
9 December 2021 15
 The Cost of Irredeemable Bonds
Since the interest payments made on irredeemable
bonds are tax deductible, it will have both a before-
and after-tax cost of debt.
The before-tax cost of irredeemable debt (Kid) can
be calculated as:
Interest rate payable
K id 
Market value of bond
The after-tax cost of debt is then easily obtained if the
company taxation rate (T) is assumed to be constant:
Kid (after tax) = Kid (1 - T)

9 December 2021 16
 The Cost of Redeemable
Bonds

• To find the cost of redeemable bonds

we need to find the overall required
return of the providers of debt
finance, which combines both revenue
(interest) and capital (principal)
returns.

9 December 2021 17
The Cost of Redeemable Bonds (Cont..)
The overall required return of the providers of debt
finance is equivalent to the internal rate of return (Kd)
of the following valuation model
I I I I  RV
P0     ..........
........ 
1  K d   1  K d  2  1  K d  3 1  K d  n

Where:
I = annual interest payment
RV = redemption value
Kd = cost of debt before tax
P0 = current market price of bond
9 December 2021 n = number of years to redemption 18
 The Cost of Redeemable Bonds
(Cont..)

• In order to estimate Kd using the valuation

model, trial and error or linear interpolation
methods can be used (as is the case for
IRR).
• Alternatively, to save the trouble of doing
an interpolation calculation, K d can be
estimated using the yield approximation
method developed by Hawanini and Vora
(1982)
9 December 2021 19
 Cost of Redeemable Debt -
Yield Approximation Method
• The yield approximation method is given by
the following equation
 P  NPD 
I  
Kd   n 
P  0.6  NPD  P 

• Where:
P = par value or face value
NPD = net proceeds from sale or market value
I = annual interest payment
n = number of years to redemption

9 December 2021 20
 Cost of Redeemable Debt - Yield
Approximation Method (Cont..)
• The yield approximation methods give the before tax
cost of debt. The after tax cost of debt can, again,
be easily obtained using the company taxation rate
(T)
Kd (after tax) = Kd (1 - T)
• More accurately, the determination of the after-tax
cost of debt should take account of the way in which
interest payments and principal are treated from a
taxation perspective.
– This may vary between different taxation systems.

9 December 2021 21
 Bank Borrowings
• The source of finance considered so far have all
been in security form and have a market price
with which to relate interest and dividend
payments to in order to calculate their cost.
• This is not true of bank borrowing or any other
debt that has no market price.
• To approximate the cost of such debts the interest
rate paid on the loan should be taken, making the
appropriate calculation to allow for the tax
deductibility of the interest payments.

9 December 2021 22
 Calculating the WACC
• Once the costs of a company’s individual sources
of finance have been calculated, the overall WACC
can be determined.
• In order to calculate the WACC, the costs of the
individual sources of finance are weighted
according to their relative importance as a source
of finance.
• WACC can be calculated either for the existing
capital structure (average basis) or for additional
incremental finance packages (marginal basis).

9 December 2021 23
 Calculating the WACC (Cont..)
• WACC was presented as:
N
R   wi Ri
i 1

• Thus, the WACC equation for a company financed

solely by debt and equity finance is represented by:

Ke x E K d 1  T  x D
Where:
WACC  
 D  E  D  E
E = Value of equity
D = Value of debt

9 December 2021 24
Calculating the WACC (Cont..)
• Note that the WACC equation will expand according to
the number of different sources that a company draws
its capital from.
• For instance, for a company using equity finance,
preference shares and both redeemable and
irredeemable debt, the equation will become:

Ke x E K ps x P K id 1  T  Di K rd 1  T  Dr
WACC    
E  P  Di  Dr E  P  Di  Dr E  P  Di  Dr E  P  Di  Dr
Where: P, Di and Dr are the value of preference shares,
irredeemable debt and redeemable debt respectively.

9 December 2021 25
 Market or Book Value
Weightings?
• The next question that needs to be
answered is how the different costs of
finance are weighted.
• Here we are faced with two choices:
– Book values or market values.
• Book values are easily obtained from a
company’s accounts while market values are
obtainable from the financial press and from
various financial databases
9 December 2021 26
 Market or Book Value
Weightings? (Cont..)
• While book values are easy to access,
their use to determine WACC cannot be
recommended.
– Book values are based on historic costs and
rarely reflect the current required return of
providers of finance, whether equity or debt.
– The nominal value of equity, for example, is
usually only a fraction of its market value.

9 December 2021 27
 The Concept of an Optimal
Capital Structure
• The issue at hand is whether financing
decisions can have an effect on investment
decisions and thereby affect the value of the
company.
– Will the way in which a company finances its
assets (i.e. how much debt a company uses
relative to equity) affect the company’s overall
cost of capital and hence company value?
– If an optimum financing mix exists, then it would
be in a company’s best interests to locate it and
move towards this optimal capital structure.

9 December 2021 28
 Factors Affecting the Level of
Return
• The level of return required by shareholders
and debt holders will reflect the risk they
are facing.
– We already know that the required rate of return
of shareholders will always be higher than that
of debt holders, due to the former facing higher
levels of risk
– What needs further clarifications are the factors
that determine the shape of the cost of debt and
the cost of equity curves faced by the company
(i.e. the relationship between those costs of
capital and the level of gearing)
9 December 2021 29
 Fig 1: Determinants of a company’s cost
of equity finance
Required rate of return

Bankruptcy
risk

Financial risk

Business risk

Risk-free rate
0 Level of gearing
9 December 2021 30
Determinants of a company’s cost

of equity finance (Cont..)

• Figure 1 summarizes the factors which
contribute to the determination of
shareholders’ required rate of return.
– As a starting point, shareholders will require at
least the risk-free rate of return (which can be
approximated by the interest yield on short-dated
government Treasury bills.
– In addition to this, they will require a premium for
commercial or business risk, which is the risk
associated with a company’s profits and earnings
varying due to systematic influences on that
company’s sector.
9 December 2021 31
Determinants of a company’s cost

of equity finance (Cont..)

• The level of business risk faced by shareholders
will vary from company to company, as will the
required premium.
– The combination of the risk-free rate and the business
risk premium will represent the cost of equity that a
company will have if it is all equity financed.
– As a company starts to gear up by taking on debt
finance, its distributable profits will be reduced by the
interest payments it is required to make, although this
reduction in profitability is lessened by the tax shield
on debt.

9 December 2021 32
Determinants of a company’s cost

of equity finance (Cont..)

• Any volatility in operating profits will be accentuated by
the need to meet interest payments, since these
payments represent an additional cost
– Further volatility in distributable profits arises if
some or all of the interest payments are on floating
rate rather than fixed rate debt, since the size of
such payments will be determined by prevailing
market interest rates.
– The volatility of distributable profits arising from the
need to meet interest payments, which is called
financial risk, will get progressively higher as a
company’s gearing level increases.
9 December 2021 33
Determinants of a company’s cost

of equity finance - Financial Risk

• In income gearing terms, this risk is
measured by financial gearing, defined
as the ratio of the percentage change in
earnings available to shareholders to
the percentage change in profit before
interest and tax.
• Shareholders will require a premium for
facing financial risk and this premium
will increase with the level of a
company’s gearing
9 December 2021 34
Determinants of a company’s cost

of equity finance (Cont..)

• Finally, at very high levels of gearing, the
possibility of the company going into
liquidation increases due to its potential
inability to meet its interest payments.
• At high gearing levels, shareholders will
require compensation for facing bankruptcy
risk in addition to their compensation for
facing financial risk, and this results in a
further steepening in the cost of equity curve.

9 December 2021 35
 Project Financing

9 December 2021 36
 What is a project?
• Collection of activities
• Pre-determined objectives
– High operating margins.
• Limited Life.
• Significant free cash flows.
• Few diversification opportunities.
– Asset specificity
• Significant initial investment.
9 December 2021 37
 What is Project Finance?
Project Finance involves a corporate
sponsor investing in and owning a
single purpose, industrial asset
through a legally independent entity
financed with non-recourse debt.

9 December 2021 38
 Structure Highlights
• Independent, single purpose company formed to
build and operate the project.
• Extensive contracting
– As many as 15 parties in upto 1000 contracts.
– Contracts govern inputs, off take, construction and
operation.
– Government contracts/concessions: one off or operate-
transfer.
– Ancillary contracts include financial hedges, insurance
for Force Majeure, etc.

9 December 2021 39
 Structure Highlights
• Highly concentrated equity and debt ownership
– One to three equity sponsors.
– Syndicate of banks and/or financial institutions provide
credit.
– Governing Board comprised of mainly affiliated directors
from sponsoring firms.
• Extremely high debt levels
– Mean debt of 70% and as high as nearly 100%.
– Balance capital provided by sponsors in the form of
equity or quasi equity (subordinated debt).
– Debt is non-recourse to the sponsors.
– Debt service depends exclusively on project revenues.
– Has higher spreads than corporate debt.

9 December 2021 40
Advantages of Project Finance
• Has longer maturity period than normal
bank loans.

• Securitization is on project assets only.

9 December 2021 41
 Disadvantages of Project
Financing
• Takes longer to structure than equivalent size
corporate finance.
• Higher transaction costs due to creation of an
independent entity. Can be up to 60bp
• Project debt is substantially more expensive
(50-400 basis points) due to its non-recourse
nature.
• Extensive contracting restricts managerial
decision making.
• Project finance requires greater disclosure of
proprietary information and strategic deals.

9 December 2021 42
 Financing Choice: Portfolio
Theory

• Combined cash flow variance (of project and sponsor)

with joint financing increases with:
– Relative size of the project.
– Project risk.
– Positive Cash flow correlation between sponsor and project.
• Firm value decreases due to cost of financial distress
which increases with combined variance.
• Project finance is preferred when joint financing
(corporate finance) results in increased combined
variance.
• Corporate finance is preferred when it results in lower
combined variance due to diversification (co-
insurance).
9 December 2021 43
 Financing choice: Options Theory
• Downside exposure of the project (underlying asset)
can be reduced by buying a put option on the asset
(written by the banks in the form of non-recourse
debt).

• Put premium is paid in the form of higher interest

and fees on loans.

• The underlying asset (project) and the option

provides a payoff similar to that of call option.

9 December 2021 44
 Financing choice: Options Theory
• The put option is valuable only if the Sponsor might
be able/willing to exercise the option.
• The sponsor may not want to avail of project finance
(from an options perspective) because it cannot walk
away from the project because:
– It is in a pre-completion stage and the sponsor has provided
a completion guarantee.
– If the project is part of a larger development.
– If the project represents a proprietary asset.
– If default would damage the firm’s reputation and ability to
raise future capital.

9 December 2021 45
 Financing Choice: Options
Theory
• Derivatives are available for symmetric risks but not
for binary risks, (things such as PRI are very
expensive).

• Project finance (organizational form of risk

management) is better equipped to handle such risks.

• Companies as sponsors of multiple independent

projects: A portfolio of options is more valuable than
an option on a portfolio.

9 December 2021 46
 Financing Choice: Equity vs.
Debt
• Reasons for high debt:

– Agency costs of equity (managerial discretion,

expropriation, etc.) are high.

– Agency costs of debt (debt overhang, risk shifting)

are low due to less investment opportunities.

– Debt provides a governance mechanism.

9 December 2021 47
 Financing Choice: Type of
Debt
• Bank Loans:
– Cheaper to issue.
– Tighter covenants and better monitoring.
– Easier to restructure during distress.
– Lower duration forces managers to disgorge cash early.
• Project Bonds:
– Lower interest rates (given good credit rating).
– Less covenants and more flexibility for future growth.
• Agency Loans:
– Reduce expropriation risk.
– Validate social aspects of the project.
• Insider debt:
– Reduce information asymmetry for future capital providers.
9 December 2021 48
 Financing Choice: Sequencing
• Starting with equity: eliminate risk shifting, debt
overhang and probability of distress (creditors’
requirement).

• Add insider debt (Quasi equity) before debt: reduces

cost of information asymmetry.

• Large chunks vs. incremental debt: lower overall

transaction costs. May result in negative arbitrage.

9 December 2021 49
 Project Finance – Choices

9 December 2021 50
 1. Purchase from internal budget using
capital already owned by the organization
• The simplest type of funding
• Involves the use of internal funds e.g. capital
already owned by the organization.
• The investment has to be compared against:
– competing calls on funds, including those for
example on increasing plant capacity;
– using funds on reserve to pay off company debt.
Note: Some internal funding will always need to
be spent on the project, even if only for the
initial appraisal to convince senior
management and external bodies of the
value of the proposed investment.
9 December 2021 51
 2. Commercial Banks
• One of the main sources
• In many cases a simple technical and financial
appraisal is required.
• The level of interest that the firm will be
charged on its loan will, as a rule, depend on:
– the size and type of the loan;
– prime central bank rates;
– the degree of risk involved in the loan; and
– the financial strength of the borrower

9 December 2021 52
 3. Debt Finance
• Debt is usually a conventional commercial bank loan,
although in some circumstances debt may also be
provided by institutional investors, most commonly
insurance companies.
• Borrowers pay interest i.e. the cost of the debt, and
repay the principal i.e. the loan amount.
• Lenders normally charge a pre-determined rate of
interest which is set by adding an "interest margin" to
the bank’s standard inter-bank lending rate.
• The interest margin is generally expressed in ‘basis
points’ representing the bank’s return on investment or
income.
• In some countries interest payments on debt may be tax
deductible and this is one of the reasons debt is thought
of as ‘cheaper’ then equity.

9 December 2021 53
 4. Equity Finance
• Represents the investment on the behalf of the owners of
the project, and usually comes from individuals,
companies involved in a project such as project sponsors
and equipment manufacturers, or sometimes from
institutional investors like insurance companies or energy
investment funds. These bodies are expected to take
some form of capital stake in the project.
• Equity differs from debt in that it receives the profit from
the project.
– If the project does well, the equity pay out could be
significant. If the project under-performs or becomes
bankrupt, however, equity investors are the last to be
paid, after the banks and other claims on the project.
Thus equity takes a higher risk and potentially
receives higher returns to compensate

9 December 2021 54
 5. Subordinated Debt
• This is debt that ranks below the main (senior) debt
in terms of its priority of payment or in liquidation.
• The senior debt is usually bank debt, and there may
be several layers of subordinated debt between the
bank debt and equity. Subordinated debt principal
and interest is paid only after the senior debt
principal and interest is paid.
• In insolvency, subordinated debt holders receive
payment only after the senior debt is paid in full.
Interest paid on subordinated debt is normally tax
deductible. Subordinated debt can be provided by
companies involved in the particular project, or can
be from third parties.

9 December 2021 55
 Mezzanine finance
• Is a general term used to describe
various financing arrangements that
rank below the senior debt.
• In most cases it may have certain
features that allow the debt to be
converted into equity

9 December 2021 56
 Bonds
• These are interest-bearing instruments issued
by companies, governments or other
organisations, and sold to investors in order to
raise capital.
– They are a type of debt.
– They tend to be long-term obligations with fixed
interest rates and repayment schedules.
– They are usually issued and sold in the public bond
markets, although increasingly some are sold
directly to institutional investors in which case the
financing is known as a "private placement".

9 December 2021 57
 7. Grants
• Are non-returnable source of funding which are
provided to projects or exporters to cover capital
costs.
• Bodies, with an interest in seeing the projects
developed, use grants to encourage developers to
consider projects which have high risks and
uncertain returns.
• They can be used in order to reduce the risk
exposure of the commercial lenders and investors,
or to cover incremental capital costs.
• Grant programmes have to be operated carefully in
a way that will not distort market forces or lead to
market collapse on withdrawal. Typically a lender
will accept a maximum of 30 to 50% of the total
equity requirement of a project from grant sources.
9 December 2021 58
 8. Insurance and Guarantees
• Not a type of funding mechanism in the strict sense
• However, insurance and loan guarantees are vital
components in financing.
– For any project, a full insurance package must be in place
before financing will be finalised.
• Lenders will have specific insurance requirements,
and insurance documents will be part of the overall
financing documentation.
• Two particular needs for insurance that are
particularly relevant in the context of this work are:
export insurance concerning the risks particular to
doing business in other countries, and technology
insurance concerning the risks particular to the
performance of the technologies
9 December 2021 59
 9. Ownership
• For projects where new a new project is being
implemented independently of the local or national
institutions, the legal control and ownership of the
plant can be described by various acronyms.
– BOO (build, own, operate) is used when ownership of the
project remains with the same company throughout its life.
– BOT (build, operate, transfer) is when the project company
retains control for a time to receive profits from operational
revenue, and then transfers ownership, often to the local
public sector utility. Similarly for
– BOOT (build, own, operate, transfer) where ownership
actually resides with the project company for a time.
– BOLT (build, own, lease, transfer) is for when the company
leases control to third parties, before transferring ownership.

9 December 2021 60
 10. Leverage Buyout (LBO)
• Takeover of a company using borrowed funds
• The target company’s assets serve as security
for the loans taken out by the acquiring firm,
which repays the loans out of cash flow of the
acquired company
• Management may use this technique to retain
control by converting a company from public
to private
• A group of investors may also borrow from
banks, using their own assets as collateral, to
take over another firm

9 December 2021 61
Project Finance Comparison with
Other Vehicles
Financing vehicle Similarity Dis-similarity

Secured debt Collaterized with a Recourse to

specific asset corporate assets

Subsidiary debt Possible recourse to

corporate balance
sheet

Asset backed Collaterized and non- Hold financial, not

securities recourse single purpose
industrial asset

LBO / MBO High debt levels No corporate sponsor

Venture backed Concentrated equity Lower debt levels;

companies ownership managers are equity
9 December 2021
holders 62
 Alternative Approach to Risk
Mitigation in Project Financing
Risk Solution
Completion Risk Contractual guarantees from
manufacturer, selecting vendors of
repute.
Price Risk hedging

Resource Risk Keeping adequate cushion in

assessment.
Operating Risk Making provisions, insurance.
Environmental Risk Insurance
Technology Risk Expert evaluation and retention
accounts.
9 December 2021 63
 Alternative Approach to Risk
Mitigation in Project Financing
Political and • Externalizing the project company by forming it abroad
Sovereign Risk or using external law or jurisdiction
• External accounts for proceeds
• Political risk insurance (Expensive)
• Export Credit Guarantees
• Contractual sharing of political risk between lenders
and external project sponsors
• Government or regulatory undertaking to cover policies
on taxes, royalties, prices, monopolies, etc
• External guarantees or quasi guarantees
Interest Rate Risk Swaps and Hedging
Insolvency Risk Credit Strength of Sponsor, Competence of management,
good corporate governance
Currency Risk Hedging

9 December 2021 64