Project Financing

Day 5

Prof. George Mathew

B.Sc., B.Tech, PGDCA, PGDM, MBA
Ph: 9400661717
[email protected]

ALLAMA IQBAL INSTITUTE OF

MANAGEMENT
 Sources of Funds
1. Short Term Sources
2. Medium-Term
3. Long Term
 Short Term Sources
• Bank credit
• Customer advances
• Trade Credit
• Factoring
• Accruals
• Commercial Paper
 Medium Term Sources

• Issue of Preference shares

• Debentures
• Bank Loan
 Long Term Sources

• Issue of shares
• Debentures
• Ploughing back of Profits
• Loan from specialized financial Institutions
 Security Financing
1. Ownership Securities(Capital Stock)
• Equity Shares
• Preference Shares
2. Creditorship Securities (Debt Capital)
Debentures or Bonds
 Equity Shares
Equity shares, also known as ordinary
Shares or common shares, represent the
owners capital in a company.
The rate of dividend on these shares
depends upon the profits of the company
Characteristics of Equity Shares
1. Maturity – Equity share provide
permanent capital to the company and
cannot be redeemed during the life time
of the company
 Debentures or Bonds

A Debenture is a document under the company’s seal

which provides for the payment of a principal sum and
interest thereon at regular intervals, which is usually
secured by a fixed or floating charge on the company’s
property.
 What is the Borrowing Mix?
• The Borrowing Mix
– The funds used to finance the operations and
the sources of the funds
– Debt
• Bank Loans
• Bonds
– Hybrid Stock – Preferred Stock
– Equity
• Shares
• Owner’s Money
10
 Objective of the Firm
• The objective of the firm
– Maximize Shareholder/Owner Wealth
– Wealth is the future cash flow of the firm
discounted back to today at the appropriate
weight
– Debt holders paid first
– Debt is leverage and can increase the wealth
of the owner
• Objective is to find the borrowing mix that
maximizes the value of the firm
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 Value of the Firm
• Value of the company “claimed” by owners
– Think of company as a project
– Value is NPV = -Inv + Σ Cash Flowi / (1+ r)I
– And r is the cost of capital, hurdle rate, or
WACC
E D
Cost of Capital  R E  R D 1  TC 
V V

12
 If Cash Flow is fixed…
• Lowest cost of capital maximizes the value of
the firm
• Find borrowing mix that results in the lowest
cost of capital
• This is the optimal capital structure of the firm
• Ways to find optimal capital structure
– Operating Income Approach
– Cost of Capital Approach
– Adjusted Present Value Approach 13
 Operating Income Approach
• What operating income is the firm capable of producing
(distribution)
• What different levels of debt will the firm be able to make
payments on debt (probability of default)
• Select an acceptable probability of default
• Compare probability of default at different borrowing
amounts…
– If you can handle more debt, add debt
– If you can not handle more debt, reduce debt
• Difficult part of the task…distribution of operating income

14
 Cost of Capital Approach
• Want to find the lowest WACC
– Lowest WACC is the combination of
borrowing that produces the highest firm
value
• As you add debt
– Cost of equity rises
E D
Cost of Capital  R E  R D 1  TC 
V V

15
 Table Cost of Capital
• Find the Market Value of Equity
• Find the Market Value of Debt
• Find WACC at the different D/E ratios…
• Look for the lowest WACC
• This is the optimal D/E ratio
– Adjustment to tax rate at higher levels of debt
– The (1 – tax rate) in WACC assumes you can
use all of the tax shield from debt
– Benefit only up to the EBIT of the company 16
 Application of Lowest WACC
• Once you find the optimal debt structure of
the firm
– You can estimate the value of the firm
– Dividend growth model

FirmValue (Cash flow to Firm)1  g / WACC  g 

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 Three Types of Capital
Capital is any form of wealth employed to
produce more wealth for the firm
• Fixed - used to purchase the permanent or
fixed assets of the business (e.g., buildings,
land, equipment, etc.)
• Working - used to support the small company’s
normal short-term operations (e.g., buy
inventory, pay bills, wages, salaries, etc.)
• Growth - used to help the small business
expand or change its primary direction.
 Equity Capital
• Represents the personal investment of the
owner(s) in the business.
• Is called risk capital because investors
assume the risk of losing their money if the
business fails.
• Does not have to be repaid with interest like
a loan does.
• Means that an entrepreneur must give up
some ownership in the company to outside
investors.
 Sources of Equity Financing
• Personal savings
• Friends and family members
• Partners
• Corporations
• Venture capital companies
• Public stock sale
 Corporate Venture Capital
• 30% of all venture capital investments
come from corporations.
• About 900 large corporations across the
globe invest in start-up companies.
• Capital infusions are just one benefit;
corporate partners may share marketing
and technical expertise.
Venture Capitalist Companies
• More than 3,000 venture capital firms
operate across the United States.
• Most venture capitalists seek
investments in the $3,000,000 -
$10,000,000 range in companies with
high-growth and high-profit potential.
• Business plans are subjected to an
extremely rigorous review – less than
1% accepted.
 Debt Financing
• Must be repaid with interest.
• Is carried as a liability on the company’s
balance sheet.
• Can be just as difficult to secure as
equity financing, even though sources of
debt financing are more numerous.
• Can be expensive, especially for small
companies, because of the risk/return
tradeoff.
• Convertible loans (very popular if IPO
might be used as an exit strategy)
 Short Term
• Bank loans – necessity of paying interest on the payment,
repayment periods from 1 year upwards but generally no
longer than 5 or 10 years at most
• Overdraft facilities – the right to be able to withdraw funds you
do not currently have
– Provides flexibility for a firm
– Interest only paid on the amount overdrawn
– Overdraft limit – the maximum amount allowed to be drawn
- the firm does not have to use all of this limit
• Trade credit – Careful management of trade credit can help
ease cash flow – usually between 28 and 90 days to pay
• Factoring – the sale of debt to a specialist firm who secures
payment and charges a commission for the service.
• Leasing – provides the opportunity to secure the use of capital
without ownership – effectively a hire agreement
 Capital structure
Determination of debt and equity
properties necessary to maximize firm’s
financial health and long-term
competitiveness.
Capital Structure refers to the
combination or mix of debt and equity
which a company uses to finance its long
term operations.
 Capital structure
Capital Structure is the optimum capital
structure that may be defined as that
capital structure or combination of debt
and equity that leads to the maximum
value of the firm.
Capital structure can affect the value
of the company by affecting either its
expected earnings or cost of capital or
both.
 Capital Structure
• Mixture of debt and equity maintained by a
firm
• How much should the firm borrow?
• What are the least expensive sources of
funds for the firm?
• What % of cash flow goes to creditors and
what % to shareholders?
• Choosing among lenders and loan types is
another job of financial manager
 Capital Structure :Debt and
Equity
• The basic feature of a debt is that it is a
promise by the borrowing firm to repay a fixed
dollar amount of by a certain date.
• The shareholder’s claim on firm value is the
residual amount that remains after the
debtholders are paid.
• If the value of the firm is less than the amount
promised to the debtholders, the shareholders
get nothing.
Debt and Equity as Options
Payoff to Payoff to
debt holders shareholders
If the value of the If the value of the
firm is more than $F, firm is less than
debt holders get a $F, share holders
maximum of $F. get nothing.
$F

$F $F
Value of the firm (X) Value of the firm (X)

Debt holders are promised If the value of the

$F. firm is more than $F,
If the value of the firm is less than $F,
share holders get
they get the whatever the firm if worth.
everything above
Algebraically, the bondholder’s Algebraically,
$F. the shareholder’s
claim is: Min[$F,$X] claim is: Max[0,$X – $F]
Combined Payoffs to Debt and Equity
Combined Payoffs to debt holders If the value of the firm is less
and shareholders than $F, the shareholder’s claim
is: Max[0,$X – $F] = $0 and the
debt holder’s claim is Min[$F,$X]
= $X.

Payoff to The sum of these is = $X

$F shareholders
If the value of the firm is more
Payoff to debt than $F, the shareholder’s claim
holders is: Max[0,$X – $F] = $X – $F and
$F the debt holder’s claim is:
Value of the firm (X)
Min[$F,$X] = $F.
Debt holders are promised
$F. The sum of these is = $X
 Capital structure-
Net Income approach
According to Net Income (NI) approach, capital
structure decision is relevant to the valuation of
the firm.
A change in the capital structure / financial
leverage will lead to a corresponding change in
the overall cost of capital as well as the total
value of the firm.
Financial leverage is measured by the ratio of
debt to equity.
 Net Income approach
Three assumptions:
1.There are no taxes
2.Cost of debt is less than the equity
capitalization rate
3.Use of debt does not change the risk
perception of investors
 Capital structure- Net Income
Approach
If the degree of financial leverage as
measured by the ratio of debt to equity is
increased, the weighted average cost of
capital will decline, while the value of the
firm as well as the market price of the
ordinary shares will increase.
The conversely, a decrease in leverage will
cause an increase in overall cost of capital
and decline both in the value of the firm as
well as the market price of equity shares.
 Capital structure-
Net Operating Income (NOI ) Approach
Leverage / capital structure is irrelevant
Any Change in leverage will not lead to any
change in the total value of the firm and the
market price of share, as the overall cost of
capital is independent of the degree of
leverage.
 MODIGLIANI-MILLER(MM)
APPAROACH
In this approach capital structure, cost of
capital and valuation is akin to the net
operating income (NOI) approach.
MM postulate supports the NOI approach
relating to the independence of the cost of
capital of the degree of leverage at any
level of debt-equity ratio.
 MODIGLIANI-MILLER(MM) APPAROACH
Basic Propositions
1.The overall cost of capital (ko) and the value of the
firm (V) are independent of it’s capital structure. Ko
and V are constant for all degrees of leverages
2. Ke is equal to the capitalization rate of a pure
equity stream plus a premium for financial risk
equal to the difference between the pure equity
capitalization rate (ke) and ki times the ratio of debt
to equity
3. The cut of rate for investment purposes is
completely independent of the way in which an
investment is financed.
 Capital structure- Traditional approach
Traditional approach is midway between NI
approach and NOI.
It is also called intermediate approach.
It resemble the NI approach that the cost of capital and
value of the firm are not independent of the capital
structure but does not support that value of the firm will
necessarily increase for all degree of leverage.
In this approach , with judicious use of debt –equity
proportions , a firm can increase its total value and
there by reduce its overall cost of capital.
 Cost of Capital
The corporation’s cost of
capital is the rate of return that
must be earned on investment
projects. It is the discount rate
that should be used when
calculating the present value of
cash flows from an investment.
 Cost of Capital
The cost of capital determines
how a company can raise money
(through a stock issue,
borrowing, or a mix of the two).
This is the rate of return that a
firm would receive if it invested in
a different vehicle with similar
risk.
 Cost Of Debt
The effective rate that a company pays on
its current debt.
This can be measured in either
before- or after-tax returns;
however, because interest expense is
deductible, the after-tax cost is seen most
often.
This is one part of the company's
capital structure, which also includes the
cost of equity.
 Cost Of Debt
A company will use various bonds, loans
and other forms of debt, so this measure
is useful for giving an idea as to the
overall rate being paid by the company to
use debt financing. The measure can also
give investors an idea as to the riskiness
of the company compared to others,
because riskier companies generally
have a higher cost of debt.
 Cost Of Debt
To get the after-tax rate, you simply
multiply the before-tax rate by one
minus the marginal tax rate (before-tax
rate x (1-marginal tax)). If a company's
only debt were a single bond in which it
paid 5%, the before-tax cost of debt
would simply be 5%. If, however, the
company's marginal tax rate were 40%,
the company's after-tax cost of debt
would be only 3% (5% x (1-40%)).
 Cost of Capital
Cost of debt (ki)=
I
B
I
Value of Debt (B)=
ki
Cost of Equity Capital

D1
(Ke) = +g
Po
 Cost Of Equity
In financial theory, the return that
stockholders require for a company.
The traditional formula for cost of equity
(COE) is the dividend capitalization
model:
A firm's cost of equity represents the
compensation that the market demands
in exchange for owning the asset and
bearing the risk of ownership
 Cost Of Equity
In financial theory, the return that
stockholders require for a company.
The traditional formula for cost of equity
(COE) is the dividend capitalization
model:
A firm's cost of equity represents the
compensation that the market demands
in exchange for owning the asset and
bearing the risk of ownership
 Cost Of Equity

cost of equity (COE) is the dividend

capitalization model:
A firm's cost of equity represents the
compensation that the market demands
in exchange for owning the asset and
bearing the risk of ownership
 Cost of Equity

Dividend/share
Cost of Equity= + growth
Market Value of Stock
 Financial Leverage
It is the firm’s ability to use fixed cost
assets or funds to increase the return to its
owners, equity share holders.
The fixed cost/return acts as the fulcrum
and the leverage magnifies the influence.
Higher the degree of leverage, higher is the
risk as well as return to the owners.
Leverage can have negative or reversible
effect also.
Financial Leverage or Trading
on Equity
The use of long-term fixed
interest bearing debt and
preference share capital along
with equity share capital is
called financial leverage or
trading on equity .
 Financial Leverage or Trading
on Equity
Funds required by an enterprise can be raised
through two sources:
• owners equity and
• outsiders, called creditor’s equity.
Financial structure is represented by the left
had side of the Balance Sheet – liabilities side.
Only long term finance are taken as capital
structure.
 Impact of Financial Leverage
• The financial leverage is used to
magnify the share holders
earnings when cost of external
fund is less than that of cost of
equity.
• The share holders earnings or
return on equity will decrease if the
cost of external fund is greater
than that of cost of equity.
Degree of Financial Leverage
(DFL)
Percentage Change in EPS
DFL 
PercentageChangeinEBIT

EBIT
DOL 
EBT
The degree of financial leverage measures
the impact of a change in operating income
(EBIT) on change in earning on equity
capital or on equity share.