PRINCIPLES OF FINANCING PROJECTS

TYPES AND SOURCES OF FINANCE

There are two main types of financing: equity and debt. Equity financing

refers to the money subscribed by investors and shareholders, whose

returns on investment are in the form of dividends and capital growth

equivalent to the value of their equity in the project organization. However,

the project organization can make dividend disbursements only

after the interest and scheduled loan repayment obligations have been

met. If the project is successful, the returns on investment for equity

holders can be substantial; if it fails, equity providers may receive no

returns. Consequently, equity holders may demand higher returns than

other debtors.

Debt financing refers to money borrowed from a number of sources,

including banks. This debt involves periodic repayments of the debt and

interest, based on agreed-upon schedules. The money borrowed through

this type of financing arrangement has to be repaid first, before the

repayment of other types of finances. This type of debt is also sometimes

known as senior debt.

Mezzanine debt -  Another type of debt financing involves loans from the project organization’s

equity holders. This type of debt, called Mezzanine debt, involves

a schedule of loan repayments and interest payments at a predetermined

rate. Mezzanine debt, however, is considered secondary to the senior debt

discussed earlier, and all loan and interest repayments on mezzanine,

debt can be made only after financial obligations to the lenders of the

senior debt have been fulfilled. Consequently, mezzanine debt involves

higher risk and correspondingly higher interest rates.

SOURCES OF FINANCE

There are both conventional and unconventional sources of finance. The

conventional sources include the company’s shareholders, banks, suppliers,

export credit, buyer and seller credit, and international investment

institutions such as World Bank and development banks such as the

Asian Development Bank. Unconventional sources of finance include

leasing assets, counter trade, forfeiting, switch trade, and debt/equity

swapping.

• Leasing assets—rather than purchasing a project asset, the project

organization leases it from a third party, who receives a return in

the form of rental for the asset.

• Counter trade—The seller accepts goods or services in lieu of cash.

For example, it is quite common in poorly developed or third world

countries to ‘‘pay’’ for a portion of a large project with commodities,

which the project developer then must sell in order to raise cash.

• Forfeiting—finance is made available through the sale of financial

instruments due to mature at some time in the future. Finance is

then provided by trading in these assets in the futures market.

• Switch trade—This process makes use of a credit surplus between

two parties to finance a relationship with a third party. For example,

if country A has a credit surplus with country B, exports from C to A

can be financed with payments from B to C.

• Debt/equity swapping—A multinational company may buy a host

country’s debt at a discount. This is redeemed in local currency

at favorable exchange rates and is used to set up local companies.

These are used by the multinational company to transfer technology,

generate foreign exchange, and create employment in the host

country.

COST OF FINANCING

The cost associated with borrowing money depends on the particular form

of capital borrowed. For example,

• The cost of equity is the dividends paid to shareholders plus any

estimate of the equity’s capital growth. The cost of equity is usually

calculated using the capital asset pricing model (CAPM). (More can

be learned about this model in any finance textbook.)

The cost of debt is the cost of debt financing, or the interest paid

on the money borrowed. While the cost of equity is payable out of

untaxed income, the cost of debt is payable out of taxed income.

• The cost of capital is the average cost of various forms of finance

used by the project organization; specifically, it is the weighted average

of the cost of the different types of capital borrowed. For example,

if the project is financed through both debt and equity, then

Cost of capital = Ratio of equity ∗ Cost of equity

+ Ratio of debt ∗ Cost of debt

PROJECT FINANCE

Project finance refers to unsecured, nonrecourse,

off-balance sheet financing of an individual project.

Project finance involves two main types of contracts: concession agreements

with the government, and off-take contracts with consumers.