CHAPTER SEVEN

PROJECT FINANCE

PROJECT MANAGEMENT
 Objectives
• After completing this unit, you will be able to:
 Define and explain the meaning of project financing.
 Understand why project finance is important.
 Discuss the characteristics of project financing.
 Identify the difference between conventional
financing and project financing.
 Identify the difference between debt financing Vs
equity financing.
 Describe and discuss the factors that determine the
capital structure.
 Why Use Project Finance
1. As an addition to its existing business rather than stand alone
basis. Such project finance is easy as it is by means of internal
accruals and/or corporate loans.
2. The lenders need high degree of confidence with reference to
timely completion of the project and without cost overrun;
technically capable, sales projections achievable and projected
cash flows are adequate and realistic. The projections should be
adequate to service the debt obligations and be robust enough to
cover any temporary problems that may arise.
3. The lenders need to ensure that the project risks are allocated to
appropriate parties other than the Project Company, or where this
is not possible, mitigated in other ways.
4. Lenders may also need to continue to monitor and control the
activities of the Project Company to ensure that the basis on which
they assessed the risks is not undermined.
 Project Financing
• Project financing may be defined as the raising of
funds required to finance a capital investment
proposal which is economically separable.
• The assets, contracts cash flows are separated
from the parent company and the assets acquired
for the projects serve as collateral for loans.
• The repayments are made from the revenue
generated from the projects.
 Characteristics of Project Financing
1. There is a presence of a special project entity.
2. The component of debt is very high and therefore
gives raise to a highly leveraged firm.
3. Project financing is separated form the parent
company’s balance sheet.
4. Debt servicing and repayments are done only from
the cash flows arising from the projects.
5. Project financier’s risks are not entirely covered by
the sponsor’s guarantee.
6. Third parties like suppliers, customers, government
and sponsors commit to share the risk of the project.
 Conventional Financing vs. Project financing
CONVENTI ONAL FI NANCI NG PROJECT FI NANCI NG
Creditor makes an assessment of repayment Cash flows from project related assets alone are
of his loan by looking at all cash flows and considered for assessing the repaying capacity.
resources of the borrower.

End use of the borrowed funds is not The creditors ensure proper utilization of
strictly monitored by the lender. the fund.

Creditors are interested only in their money Project financiers are keen to watch the
getting repaid. performance of the enterprise and suggest
measures.

Project financiers can appoint their nominee is

the Board of directors of their clients.
 Debt Financing Vs Equity Financing
• Businesses need finance, either to expand an already
existing business, or to start a new one.
• There are three alternatives for financing a business,
namely, self financing, equity financing and debt
financing.
• Self financing involves a huge risk and is generally taken
up by small business owners.
 That leaves us with the other two financing methods, that
is, debt and equity financing.
 Let's compare debt financing vs. equity financing on
various counts and it is important to understand their
meaning.
• Debt financing means when a business owner, in order to raise
finance, borrows money from some other source, such as a bank.
The business owner has to pay back this loan or debt within a pre-
determined time period along with the interest incurred on it. The
lender has no ownership rights in the borrower's company. Debt
financing can be both, short term as well as long term.
• Equity financing means when a business owner, in order to raise
finance, sells a part of the business to another party, such as venture
capitalists or investors. Under equity financing, the financier has
ownership rights equivalent to the investment made by him in the
business, or in accordance with the terms and conditions set
between him and the business owner. This is the main difference
between debt financing and equity financing. In equity financing,
the financier has a say in the functioning of the business as well.
 Difference between debt and equity
Points to compare Debt Equity

Process Procedure of raising money is There are a number of

easier security laws and regulations
Ownership Rights the business owner has full the invest has ownership
control and ownership of the rights and decision making
business power

Rights over Profit Lenders only have a right over Owner has the right over the
the principal loan profit and risks

Ease of doing Business decisions and rights of The shareholders have to be

running the business, solely updated and consulted about
lie with the owner. the business regularly

Repayment no reservations improves the scope of

arranging financing
Cost to Company the loan amount is already All in excess of the amount
known and fixed they invested
Future Funding Higher loan higher risk improves the scope of
arranging financing for the
business in future
 Advantages of Debt Compared To Equity
• Because the lender does not have a claim to equity in the business, debt
does not dilute the owner's ownership interest in the company.
• A lender is entitled only to repayment of the agreed-upon principal of the
loan plus interest, and has no direct claim on future profits of the business. If
the company is successful, the owners reap a larger portion of the rewards
than they would if they had sold stock in the company to investors in order
to finance the growth.
• Except in the case of variable rate loans, principal and interest obligations
are known amounts which can be forecasted and planned for.
• Interest on the debt can be deducted on the company's tax return, lowering
the actual cost of the loan to the company.
• Raising debt capital is less complicated because the company is not required
to comply with state and federal securities laws and regulations.
• The company is not required to send periodic mailings to large number of
investors, hold periodic meetings of shareholders, and seek the vote of
 Disadvantages of Debt Compared To
Equity
• Unlike equity, debt must at some point be repaid.
• Interest is a fixed cost which raises the company's break-even point. High interest
costs during difficult financial periods can increase the risk of insolvency. Companies
that are too highly leveraged (that have large amounts of debt as compared to
equity) often find it difficult to grow because of the high cost of servicing the debt.
• Cash flow is required for both principal and interest payments and must be
budgeted for. Most loans are not repayable in varying amounts over time based on
the business cycles of the company.
• Debt instruments often contain restrictions on the company's activities, preventing
management from pursuing alternative financing options and non-core business
opportunities.
• The larger a company's debt-equity ratio, the more risky the company is considered
by lenders and investors. Accordingly, a business is limited as to the amount of debt
it can carry.
• The company is usually required to pledge assets of the company to the lender as
collateral, and owners of the company are in some cases required to personally
guarantee repayment of the loan.
Sources of finance
 Equity/Ordinary Shares
• Equity share represent ownership capital and its owners-
ordinary share holders/ equity holders-share the reward and
risk associated with the ownership of corporate enterprises.
• They are also called ordinary shares in contrast with preference
shares.
• However, their liability, unlike the liability of the owner in a
proprietary firm and the partners in a partnership concern, is
limited to their capital contributions.
• Some terms:
 Authorized Capital
 Issued Capital
 Subscribed Capital
 Paid up Capital
 Advantages and Disadvantages of Equity
• Advantages of Equity:
• Equity shares do not create any obligation to pay a fixed rate of dividend.
• Equity shares can be issued without creating any charge over asset of the company.
• It is permanent source of capital and the company has not to repay it except under
liquidation
• Equity share holders are the real owners of the company who have the voting rights
• In case of profits, equity shareholders are the real gainers by way of increased dividends
and appreciation in the value of shares.
• Disadvantages of Equity shares:
• If only equity share are issued, the company cannot take the advantage of trading on
equity.
• As equity capital cannot be redeemed, there is a danger of overcapitalization.
• Equity shareholders can put obstacles in management by manipulation and organizing
themselves.
• During prosperous periods higher dividends have to be paid leading to increase the value
of shares in the market and speculation.
• Investors who desire to invest in safe securities with a fixed income have no attraction for
such shares.
 Preference Shares
• Preference share is a unique type of long term financing in that it
combines some of the features of equity as well as debentures. As a
hybrid security or of financing:
 It carries a fixed/stated rate of dividend.
 It ranks higher than equity as a claimant to the income/assets.
 It normally does not have voting rights.
 It does not have a share in residual earnings/assets.
• A preference share ordinarily does not carry voting rights. It is,
however, entitled to every resolution if:
– The dividend is in arrears for 2 years in respect of cumulative preference
shares.
• •The preference dividend has not been paid for a period of
two/more consecutive preceding years or for an aggregate period of
three/more years in the preceding six years ending with the expiry of
 Advantages of Preference Shares
• There is no legal obligation to pay preference dividend the
company does not face bankruptcy or legal action if it skips
preference dividend.
• There is no redemption liability in the case of perpetual
preference shares. Even in the case of redeemable preference
shares, financial distress may not much because (i) periodic sinking
fund payments are not required. (ii) can be delayed without
significant penalties.
• Preference capital is generally regarded as part of net worth.
Hence, it enhances the credit worthiness of the firm.
• Preference shares do not, under normal circumstances, carry
voting rights. Hence, there is no dilution of control.
• No collateral is pledged in favor of preference shareholders.
Hence, the mort gable assets of the firm are conserved.
 Shortcomings of the Preference Share
Capital:
• Compared to debt capital, it is said to be a more expensive
sourer of financing because the dividend paid to
preference shareholders is not, unlike debt interest, a tax –
deductible expense.
– Though there is no legal obligation to pay preference dividends,
skipping them can adversely affect the image of the firm in the
capital market.
– Compared to equity shareholders, preference shareholders
have a priority claim on the assets and earnings of the firm.
– If a firm skips preference dividends for three years, it has to
grant voting rights to the preference shareholders, on matters
affecting them.
 Term loans
• The term loans given by financial institutions and banks have
been the primary source of long term debt for private firms
and most public firms.
• Terms loans, also referred to as term finance, represent a
source of debt finance, which is generally repayable in less
than 10 years.
• They are employed to finance acquisition of fixed assets and
working capital margin.
• Term loans differ from short-term bank loans, which are
employed to finance short-term working capital need and tend
to be self-liquidating over period of time usually less than one
year.
 Debenture/ Bonds/ Notes
• Promissory note, debenture / bonds, represent Creditors
hip securities and debenture holders are long term
creditors of the company.
• As a secured instrument, it is a promise to pay interest and
repay principal at stipulated times. In contrast to equity
capital, which is a variable income (dividend/ security, the
debenture / notes are fixed income (interest) security.
• A fixed rate of interest is paid on debentures. The interest
on debenture is a charge on the profit and loss account of
the company. These debentures are generally given a
floating charge over the assets of the company. When the
debentures are secure, they are paid on priority in
comparison to all other creditors.
 Advantages of Debentures
• Debentures provide long-term funds to a company
• The rate of interest payable on debentures is usually, lower than the
rate of dividend paid on shares
• The interest of debentures is a tax-deductible expense and hence the
effective cost of debentures is lower as compared to ownership
securities where dividend is not a tax-deductible expense.
• Debt financing does not result into dilution control because debenture
holders do not have any voting rights
• A company can trade on equity by mixing debentures in its capital
structure and there by increase its earning per share.
• Many companies prefer issue of debentures because of the fixed rate of
interest attached to them irrespective of the changes in price levels.
• Debentures provide flexibility in the capital structure of a company as
the same can be redeemed as and when the company has surplus
funds and desires to do so.
 Limitations of Debentures
• The fixed interests charges are repayment of principal amount on maturity
legal obligations of the company. These have to be paid even when there
are no profits.
• Charges on the assets of the company and other protective measures
provided to investors by the issue of debentures usually restrict a company
from using this source of finance. The company cannot raise further loans
against the security of assets already mortgaged to debenture holders.
• The use of debt financing usually increases the risk perception of investors
in the firm. This enhanced financial risk increases the cost of equity capital.
• Cost of raising finance through debentures is also high because of high
stamp duty
• A company who’s expected future earnings is not stable or who deals in
products with highly elastic demand or who does not have sufficient fixed
assets to offer as security to debenture holders cannot use this source of
raising funds to its benefit.
• Working Capital Advance:
• Working capital advance by commercial banks
represents the most important source for financing
current assets.
• Forms of Bank of Finance:
• Working capital advance is provided by commercial
banks in three primary ways;(i) cash credit /
Overdrafts,(ii) loans, and (iii) purchase/discount of
bills. In addition to these direct forms, commercial
banks help their customers in obtaining credit from
other sources through the letter of credit
 Miscellaneous Sources
• Apart from the above-mentioned sources of finance, there are several other ways in
which finance may be obtained. These include:
• Deferred Credit: Many times the suppliers of machinery provide deferred credit facility
under which payment for the purchase of machinery is made over a period of time. The
interest rate on deferred credit and the period of payment vary rather widely. Normally,
the supplier of machinery when he offers deferred credit facility insists than the buyer
should furnish a bank guarantee.
• Lease finance: A lease finance represents a contractual arrangement whereby the lessor
grants the lessee the right to use an asset in return for periodic lease rental payments.
While leasing of land, buildings and animals has been known from times immoral, the
leasing of industrial equipment's is a relatively recent phenomenon.
• Hire Purchase agreement: The hire purchases the asset and gives it on hire to the hirer
• The hirer pays regular hire purchase installments over a specified period of time. These
installments cover the interest as well as principal repayment. When the hirer pays last
installment, the title of the asset is transferred from the hire to the hirer. The hire charges
interest on flat basis.
• Unsecured Loans: The promoters to fill the gap between the promoter contributions
required institutions typically provide unsecured loans and the equity capital subscribed
to by the promoters. These loans are subsidiary to the institutional loans.
 Cost of capital
• What does it mean and basic features?
Assignment
 Financing institutions
1. Equity Financing:
 Equity is capital invested in a business by its owners, and it is ‘at risk’ on a permanent basis.
 Because it is permanent, equity capital creates no obligation by an entrepreneur to repay
investors, but raising equity requires sharing ownership.

2. Venture Capital:
 Venture capital is an alternative form of equity financing for small businesses.
 Venture capitalists focus on high risk entrepreneurial businesses. They provide:
 start-up (seed money) capital to new ventures,
 development funds to businesses in their early growth stages, and
 expansion funds to rapidly growing ventures that have the potential to “go
public” or that need capital for acquisitions.
3. Personal Sources:
 Entrepreneurs must look first to individual resources for startup capital.
 These include cash and personal assets that can be converted to cash.
 Family members and close friends become involved as informal investors.
4. Commercial Banks:
 Most commercial loans are made to small businesses. Commercial banks provide unsecured
and secured loans.
 An unsecured loan is a personal or signature loan that requires no collateral; the entrepreneur is
granted the loan on the strength of his reputation.
 Secured loans are those with security pledged to the bank as assurance that the loan will be repaid.
5. Finance Companies:
 There are three types of finance companies, and although all are asset-based lenders, each
serves a different clientele.
– Sales Finance Companies: focus on loans for specific purchases like automobiles and farm
machinery.
– Consumer Finance Companies: focus on short term loans secured by personal assets, and
most consumer loans are for small amounts at high rates of interest. These loans are
typically negotiated directly between finance companies and consumers for purchases such as
furniture, appliances, vacation trips and home repairs.
– Commercial Finance Companies: are focused predominantly on small business and
agricultural lending. Their primary business is making loans on commercial, industrial and
agricultural equipment.
6. Leasing:
 Leasing allows a small firm to obtain the use of equipment, machinery or
vehicles without owning them.
 Ownership is retained by the leasing company, although in many cases there is
a purchase option at the end of the lease period.
7. Hire Purchase:
 Hire purchase provides the immediate use of the asset and also ownership of
it, provided that payments according to the agreement are made.
8. Factoring:
 Factoring is a specialist form of finance to provide working capital to young,
undercapitalized businesses.
 A small firm, which grants credit to its customers, can soon have considerable
sums of money tied up in unpaid invoices.
 Factoring is a method of releasing these funds; the factoring company takes
responsibility for collection of debts and pays a percentage (Usually 80%) of
the value of invoices of the issuing company.