Modes of Project Financing

PROJECT FINANCING, PLANNING, & EVALUATION

Khalid Jamil Ansari

WHY PREFERRENCE IS GIVEN TO PROJECT FINANCING?

What are the different sources of project financing available?

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?

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

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?

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 projects may be preferable to internal funds

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?

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)

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?

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

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

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

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

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)

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)

What information is a bank likely to want?

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?

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)

Balance Sheet (in Rs.’000)

Capital & liabilities

Share capital 60

Retained 42profits

Accounts 23payable ____ 125

Assets

Equipment 73

Inventory 21

Accounts 29receivable

Cash 2___125

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

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

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

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

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

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

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

Investment projects

• Investment projects and company value

• Discussion of experiences with investment projects

• Typical project types & goals

Capital budgeting —Introduction

• Capital budgeting definition and main implementation steps

Capital budgeting —Profitability assessment

• Estimating project profitability with Net Present Value (NPV)– Time value of money & discounting

• Alternative profitability indicators– NPV, IRR, Payback

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

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 ApproachesScoring ModelsBenefit ContributionEconomic Models

Cost/Benefit AnalysisBenefit Measurement Methods

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

• Discounted Cash Flow

• Net Present Value

• Benefit/Cost RatioSimply put it is the financial value of the benefit

divided by the financial cost.

$Benefit

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 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

“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 ValueLets 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 TableYears 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 TableYears 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

• Discounted Cash Flow

Dictionary of Accounting, Ralph Estes

Second Edition, MIT Press, 1995

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.

• Discounted Cash FlowInitial Project Expense = $5,000

(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

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

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

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

We are looking for a factor of 1.2008

• 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

• Discounted Cash Flow–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

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

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

Modes of Project Financing

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