Financing of Projects

Prof.ASHALATHA
J K S H I M, NITTE
 Financial Decisions are Relatively Easier
Financing Decisions
• Financing decisions take place in
capital markets which are
approximately perfect.
• While making financial decisions,
you can observe the value of
similar financial assets
• There are very few opportunities
in the realm of financing that have
an NPV that is significantly
different from zero
Investment Decisions
• Investment decisions take place in
real markets which tend to be
imperfect.
• While making investment decisions,
you have to estimate the value of the
capital projects.
• There are many opportunities in the
realm of capital budgeting that have
an NPV that is significantly different
from zero.

Given the intense competition in capital market, financial economists argue that securities
are fairly priced. Put differently, they believe that the capital market is efficient.

Prof.ASHALATHA
J K S H I M, NITTE
 Basic Differences between Equity and Debt
Equity Debt
  Equity shareholders have a  Creditors (suppliers of debt)
residual claim on the income have a fixed claim in the
and the wealth of the firm form of interest and principal
payment
  Dividend paid to equity  Interest paid to creditors is a
shareholders is not a tax tax deductible payment
deductible payment
 Equity ordinarily has indefinite  Debt has a fixed maturity
life
 Equity investors enjoy the  Debt investors play a passive
prerogative to control the role – of course, they impose
affairs of the firm certain restrictions on the way the
firm is run to protect their interest

Prof.ASHALATHA
J K S H I M, NITTE
 Key Factors in Determining the Debt - Equity Ratio

The key factors in determining the debt-equity ratio for a

project are:
 
   Cost
   Nature of assets
   Business risk
   Norms of lenders
   Control considerations
Market conditions

Prof.ASHALATHA
J K S H I M, NITTE
 A Checklist
Use more equity when Use more debt when
  The corporate tax rate applicable  The corporate tax rate
is negligible applicable is high
   Business risk exposure is high  Business risk exposure is

 low
  Dilution of control is not an  Dilution of control is an
important issue issue
  The assets of the project are  The assets of the project
mostly intangible are mostly tangible
  The project has many valuable  The project has few growth
growth options options

Prof.ASHALATHA
J K S H I M, NITTE
 Sources of Finance
Part A Sources of Finance

Internal Working capital Miscellaneous

Securities Term loans advances sources
Accruals
• Equity
• Preference
• Bonds

Part B
Sources of Finance

Equity Debt

• Equity • Bonds
• Preference • Term loans
• Internal • Working capital advances
accruals
• Miscellaneous sources
Prof.ASHALATHA
J K S H I M, NITTE
 Internal Accruals
Internal accruals of a firm consist of depreciation amortisation,

and retained earnings.

Pros
• Readily available
• No dilution of control
Cons
• Opportunity cost is high

Prof.ASHALATHA
J K S H I M, NITTE
 Equity Capital
Equity capital represents ownership capital as equity shareholders
collectively own the company. They enjoy the rewards and bear
the risks of ownership
• Authorised capital
• Issued capital
• Subscribed capital
• Paid-up capital
• Par value
• Issue price
• Book value
• Market value
Prof.ASHALATHA
J K S H I M, NITTE
 Rights of Equity Shareholders

• Right to Income

• Right to Control

• Pre-emptive Right

• Right in Liquidation

Prof.ASHALATHA
J K S H I M, NITTE
 Shareholder Voting

• Majority Rule Voting

• Proportionate Rule Voting

Prof.ASHALATHA
J K S H I M, NITTE
 Preference Capital

Preference capital represents a hybrid form of financing. It partakes

some characteristics of equity and some attributes of debt.

Equity Debt
• Dividend not an obligatory • Dividend rate is fixed
payment
• Dividend not a tax-deductible • No voting right

Prof.ASHALATHA
J K S H I M, NITTE
 Preference Capital
Pros
• No legal obligation to pay dividends
• Enhances creditworthiness
• No dilution of control
Cons
• Costly source
• Skipping preference dividends adversely affects image
• Voting rights under certain conditions

Prof.ASHALATHA
J K S H I M, NITTE
 Debentures (or Bonds)

Akin to promissory notes, debentures are instruments for raising

debt finance. Debenture holders are the creditors of the company.
The obligation of a company toward its debenture holders is similar
to that of a borrower who promises to pay interest and principal at
specified times. Debentures often provide more flexibility than term
loans as they offer greater choice with respect to maturity, interest
rate, security, repayment, and special features.

Prof.ASHALATHA
J K S H I M, NITTE
 Features of Debentures

• Trustee
• Security
• Maturity
• Redemption
• Fixed rate vs. floating rate
• Embedded options

Prof.ASHALATHA
J K S H I M, NITTE
Innovations in Debentures (Bonds)

• Deep discount bonds

• Convertible bonds
• Floating rate bonds
• Secured premium notes
• Indexed bonds

Prof.ASHALATHA
J K S H I M, NITTE
Advantages and Disadvantages of Debt Financing
Advantages
• Tax deductibility of interest
• No dilution of control
• Lower issue costs
• Debt servicing burden is generally fixed in nominal
terms
• Tailor-made maturity
Disadvantages
• Fixed interest and principal repayment obligation
• Increased leverage raises the cost of equity
• Restrictive covenantsProf.ASHALATHA
J K S H I M, NITTE
 Methods of Offering

There are different ways in which a company may raise

finances in the primary market
• Public offering
• Rights issue
• Private placement
• Preferential allotment

Prof.ASHALATHA
J K S H I M, NITTE
 Initial Public Offering (IPO)
The first public offering of equity shares of a company, which is
followed by a listing of its shares on the stock market, is called
the IPO
Benefits Costs
  Access to a larger pool of  Dilution
capital
   Respectability  Loss of flexibility
   Lower cost of capital  Disclosures and
compared to private placement accountability

  Liquidity  Periodic costs

Prof.ASHALATHA
J K S H I M, NITTE
 The IPO Process

From the perspective of merchant banking the IPO process

consists of four major phases:
• Hiring the merchant bankers
• Due diligence and prospectus preparation
• Marketing
• Subscription and allotment

Prof.ASHALATHA
J K S H I M, NITTE
 Seasoned Equity Offering

For most companies their IPO is seldom their last public issue. As
companies need more finances, they are likely to make further
trips to the capital market with seasoned equity offerings, also
called secondary offerings.

While the process of a seasoned equity offering is similar to that of

an IPO, it is much less complicated. The company may employ the
merchant bankers who handled the IPO. Further, with the
availability of secondary market prices, there is no need for
elaborate valuation. Finally, prospectus preparation and road
shows can be completed with less effort and time than required
for the IPO.

Prof.ASHALATHA
J K S H I M, NITTE
 Bond Offering
The bond offering process is similar to the IPO process. There
are, however, some differences:
• Bond offering emphasises stable cash flows whereas equity
offering highlights the company’s growth prospects.
• Security
• Credit rating
• Debenture redemption reserve
• Trustees

Prof.ASHALATHA
J K S H I M, NITTE
 Summary Comparison of the Various Methods
Public Rights Private
Preferential
Issue Issue Placement Allotment

• Amount that can Large Moderate Moderate Moderate

be raised
• Cost of issue High Negligible Negligible Negligible

• Dilution of Yes No Yes Depends

control
• Degree of Large Irrelevant Small No
underpricing
• Market Negative Neutral Neutral Neutral
Prof.ASHALATHA
J K S H I M, NITTE
 Term Loans
Term loans, also referred to as term finance, represent a source
of debt finance which is generally repayable in less than 10
years. The key features of term loans relate to :
• Currency
• Security
• Interest payment and principal repayment
• Restrictive covenants

Prof.ASHALATHA
J K S H I M, NITTE
 Term Loan Procedure
• Submission of loan application
• Initial processing of loan application
• Appraisal of the proposed project
• Issue of the letter of sanction
• Acceptance of the terms and conditions by the
borrowing unit
• Execution of loan agreement
• Creation of security
• Disbursement of loans
• Monitoring
Prof.ASHALATHA
J K S H I M, NITTE
 Working Capital Advances

• Cash credits / overdrafts

• Loans
• Purchase / discount of bills
• Letter of credit

Prof.ASHALATHA
J K S H I M, NITTE
 Miscellaneous Sources

• Deferred credit
• Lease and hire purchase finance
• Unsecured loans and deposits
• Special schemes of institutions
• Subsidies and sales tax deferments and
exemptions
• Short term loans from financial institutions
• Commercial paper
• Factoring
• Securitisation
Prof.ASHALATHA
J K S H I M, NITTE
Raising Capital in International Markets

• Euromarkets
• Domestic markets of various countries
• Export credit agencies

Prof.ASHALATHA
J K S H I M, NITTE