WSU 2018

UNIT 6
PROJECT FINANCING
7.1. Source of Project Finance
Introduction
There are two types of project financing: equity and debt financing. When looking for money, you
must consider your company’s debt-to-equity ratio. The relation between amounts borrowed and
amounts invested to the business by the owners. The more money owners have invested in their
business, the easier it is to attract financing.

The proportion of debt to equity depends on how well the financial market is organized and the
availability of debt financing. In addition, the existence of capital markets and the legal environment
governing it will have a critical impact. However, shortage of financial resources will be a critical
constraint of implementing feasible investment projects.

7.1.1. Loan/ debt financing

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.

There are many sources for debt financing: banks, savings and loans, commercial finance companies,
and the microfinance institutions. State and local governments have developed many programs in
recent years to encourage the growth of small businesses in recognition of their positive effects on the
economy.

Family members, friends, and farmer associates are all potential sources, especially when capital
requirements are smaller. Traditionally, banks have been the major source of small business funding.
Their principal role has been as a short-term lender offering demand loans, seasonal lines of credit,
and single-purpose loans for machinery and equipment.

In addition to equity considerations, lenders commonly require the borrower’s personal guarantees in
case of default. This ensures that the borrower has a sufficient personal interest at stake to give
paramount attention to the business. For most borrowers this is a burden, but also a necessity.

7.1.2. Equity
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

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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.

The basic differences between shareholders’ funds (referred to as equity) and loan a fund (referred to
as debt) falls on:

 Process: Procedure of raising money through debt financing is easier, than raising money through
equity financing. In equity financing, there are a number of security laws and regulations, which
have to be complied by the business. Such rules are not applicable for debt financing.
 Ownership Rights: In debt financing, the business owner has full control and ownership of the
business. In equity financing, the investor or the venture capitalist has ownership rights, as well as
decision making power, in running the business.
 Rights over Profit: In debt financing, the lenders only have a right over the principal loan and the
interest incurred on it. They have no rights over the profits or revenues generated by the business.
Once the loan is repaid, the relationship between the lender and the business owner also, ends in
debt financing.
 Ease of doing Business: In debt financing, decisions and rights regarding running the business,
solely lie with the owner. Whereas in equity financing, the shareholders and investors have to be
updated and consulted about the business regularly. So, it is easier to do business with debt
financing, than with equity financing.
 Repayment: If the investors are backing the business, there will be no problem in arranging
finance for the business in future, as investors lend credibility to a business and lenders will have
no reservations in giving loans to such businesses. Thus, equity financing improves the scope of
arranging financing for the business in future. However, if the business has taken too much loan,
that is, its debt to equity ratio is on a higher side, the investors will not like to invest in such a
business as it's a "high risk" venture.
 Cost to Company: In debt financing, the loan amount is already known and fixed, so the business
owner can make a provision for it beforehand. Also, the interest incurred on loan in debt
financing can be deducted from the corporate tax . Thus, cost to company in debt financing is
easy to forecast, plan and reimburse. On the other hand, in equity financing, if the business

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generates huge profits, the investor and the venture capitalist have to be paid back money, which
is much in excess of the amount they invested.
 Future Funding: if the investors are backing the business, there will be no problem in arranging
finance for the business in future, as investors lend credibility to a business and lenders will have
no reservations in giving loans to such businesses. Thus, equity financing improves the scope of
arranging financing for the business in future. However, if the business has taken too much loan,
that is, its debt to equity ratio is on a higher side, the investors will not like to invest in such a
business as it's a "high risk" venture.
Thus, after comparing debt financing vs. equity financing, it can be concluded that both have their
pros and cons. Ideally, a business should have a mix of debt and equity financing with the debt
amount comparatively low, so that debt management becomes easy. However, it is up to the owner of
the business to decide where his preferences lie. A business owner who wants full authority over the
business, should choose debt financing .While an owner who is willing to share his risks and profits
should adopt for equity financing.

 Debt vs. Equity -- Advantages and Disadvantages

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 shareholders before taking certain
actions.

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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.

 Factors Determining Capital Structure (debt equity ratio)

The key considerations in determining the debt equity ratio or capital structure are:
i) Earning Per Share: Earning per share is simply equity earnings divided by the number of
outstanding equity shares, is regarded as an important financial number that firms would like to
improve. Hence, we need to understand how sensitive is earnings per share (EPS) to changes in
profit before interest and tax(PBIT) under different financing alternatives.
ii) Risk; concerns the deviation of one or more results of one or more future events from their
expected value. Technically, the value of those results may be positive or negative. However,
general usage tends to focus only on potential harm that may arise from a future event, which
may accrue either from incurring a cost ("downside risk") or by failing to attain some benefit
("upside risk).The two principal sources of risk in a firm are:
Business risk
Financial risk
a) Business risk: A business risk is a circumstance or factor that may have a negative impact on
the operation or profitability of a given company. Sometimes referred to as company risk, a
business risk can be the result of internal conditions, as well as some external factors that may

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be evident in the wider business community. Business risk can be brought by, demand
variability, price variability, variability of input prices and proportions of fixed assets.
b) Financial risk: It represents the risk emanating from financial leverage. When a firm employs
a high proportion of debt in its capital structure, it carries a high burden of fixed financial
commitments. Equity share holders, who have a residual interest in the income and wealth of
the firm are naturally exposed to the risk arising from such fixed commitments. Equity share
holders face this risk, also referred to as financial risk, in addition to business risk. Generally,
the affairs of the firm are, or should be managed in the way that the total risk born by equity
share holders is not unduly high. This implies that if the firm is exposed to a high degree of
business risk, its financial risk should be kept low and vice versa.
iii) Control: The rights issue options severely limits the financing ability of the firm-the present
owners may lack resources or inclination or both-the options which may merit serious
considerations are debt capital and public issue of equity capital. In evaluating the options,
among other things, the issue of control is important.
iv) Flexibility: Flexibility for practical purpose means that the firm does not fully exhaust its debt
capacity. But differently, it implies that the firm maintains reserve borrowing power to enable it
to raise debt capital to fund unforeseen needs.
v) Nature of assets: The nature of a firm’s assets has an important bearing on its capital structure.
If the assets are primarily tangible (plant, machinery and buildings) and have a liquid
resale/secondary market, debt finance is used more. For example, electric utility companies use
more debt because their assets are mainly tangible, physical in nature. on the other hand if the
assets are primarily intangible(brands and technical know-how),debt finance is used less. for
example, software companies use very little debt, as their assets are mainly intangible.
 Situations that enforce a firm to use More Debt/ Equity

Use more equity when

The corporate tax rate applicable to the firm is negligible.
Business risk exposure is high.
Dilution of control is not an important issue.
The assets of the firm are mostly intangible.
The firm has many valuable growth options.

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Use more debt when
The corporate tax rate applicable to the firm is high.
Business risk exposure is low.
Dilution of control is an issue.
The assets of the firm are mostly tangible.
The firm has few growth options.

7.1.3. Leasing
Lease is an agreement between two parties whereby one party allows the other to use
his/her property for a certain period of time in exchange for a periodic fee. The property covered in a
lease is usually real estate or equipment such as an automobile or machinery. There are two main
kinds of leases. A capital lease is long-term and ownership of the asset transfers to the lessee at the
end of the lease. An operating lease, on the other hand, is short-term and the lesser retains all rights
of ownership at all times.

Elements of Leasing

Leasing is one of the important and popular parts of asset based finance. It consists of the following
essential elements. One should understand these elements before they are going to study on leasing.

 Parties: These are essentially two parties to a contract of lease financing, namely the owner
and user of the assets.
 Leaser: Leaser is the owner of the assets that are being leased. Leasers may be individual
partnership, joint stock companies, corporation or financial institutions.
 Lease: Lease is the receiver of the service of the assets under a lease contract. Lease assets
may be firms or companies.
 Lease broker: Lease broker is an agent in between the leaser (owner) and lessee. He acts as
an intermediary in arranging the lease deals.
 Lease assets: The lease assets may be plant, machinery, equipments, land, automobile,
factory, building etc.

Advantages of Leasing

- Balanced Cash Outflow:- The biggest advantage of leasing is that cash outflow or payments
related to leasing are spread out over several years, hence saving the burden of one-time
significant cash payment. This helps a business to maintain a steady cash-flow profile.
- Quality Assets:- While leasing an asset, the ownership of the asset still lies with the lesser
whereas the lessee just pays the rental expense. Given this agreement, it becomes plausible for
a business to invest in good quality assets which might look unaffordable or expensive
otherwise.

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- Better Usage of Capital:-Given that a company chooses to lease over investing in an asset by
purchasing, it releases capital for the business to fund its other capital needs or to save money
for a better capital investment decision.
- Tax Benefit:- Leasing expense or lease payments are considered as operating expenses, and
hence, of interest, are tax deductible.

- Low Capital Expenditure:- Leasing is an ideal option for a newly set-up business given that
it means lower initial cost and lower investment requirements.
- No Risk Of Obsolescence:-For businesses operating in the sector, where there is a high risk of
technology becoming obsolete, leasing yields great returns and saves the business from the
risk of investing in a technology that might soon become out-dated. For example, it is ideal
for the technology business.
- Termination Rights:- At the end of the leasing period, the lessee holds the right to buy the
property and terminate the leasing contract, thus providing flexibility to business.

Disadvantages:
 The lessee gets only the right to use the asset. In case the leasing company is wound up the
asset may be taken back from the lessee thereby disrupting his operations.
 The lessee cannot make alterations or improvements in the asset without the prior approval of
the lessor. The lessor may also put some restrictions on the lessee.
 The lessee has to pay lease rentals on a regular basis to the lessor.

7.2. Financial Institutions

Financial institutions are financial intermediaries, which are specialized financial firms, that facilitate
the transfer of funds from savers to demanders of capital. They accept savings form customers and
lend this money to other customers or they invest it. In many instances, they pay savers interest on
deposited funds. In some cases, they impose service charges on customers for the services they
render. For example, many financial institutions impose service charges on current accounts.

The key participants in financial transactions of financial institutions are individuals, businesses, and
government. By accepting the savings from these parties, financial institutions transfer again to
individuals, business firms, and governments. Since financial institutions are generally large, they
gain economies of scale in the transfer of money between savers and demanders. By pooling risks,
they help individual savers to diversify their risk.

The major classes of financial institutions include commercial banks, savings and loan associations,
mutual savings banks, credit unions, pension funds and life insurance companies. Among these,
commercial banks are by far the most common financial institutions in many countries worldwide. In
Ethiopia too, commercial banks are the major institutions that handle the savings and borrowing
transactions of individuals, businesses, and governments.

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