6.
Introduction to Project Financing [5 hrs]
6.1 Project finance
6.2 Capital Structure Planning
6.3 Capital Budgeting Decision
Finance
• Every business transaction involves cash directly or indirectly.
• Finance is concerned with everything that takes place in the
conduct of a business.
• Finance is concerned with the procurement of funds.
6.1 Project finance
• Project finance is the long-term financing in infrastructure
& industrial projects on a non-recourse or limited
recourse basis.
• Project finance involves procurement of funds & their
effective utilization in the projects.
• Project financings generally require large amounts of
capital.
• Project financing involve high transaction costs.
Project finance Contd.
• Risk identification & allocation is a key component of
project finance.
• A project may be subject to a number of technical,
environmental, economic & political risks.
• World Bank is a major player in sponsoring
infrastructure projects & providing finance in developing
countries.
• World Bank defines project finance as the “use of
nonrecourse or limited-recourse financing.”
Project finance Contd.
• In nonrecourse finance, lenders are repaid only from
cash flow generated by the project or, in the event of
complete failure, from the value of project’s assets.
• It is defined as “the financing of long-term infrastructure,
industrial projects and public services based upon a non-
recourse or limited recourse financial structure where
project debt and equity used to finance the project are
paid back from the cash flow generated by the project”
(International Project Finance Association).
Project finance Contd.
• Project financings tend to be large-scale projects that
require debt and equity capital, from hundreds of
millions to billions of rupees.
• Project finance can raise larger amounts of long-term,
foreign equity & debt capital.
• Project finance is a complex financing mechanism that
can require significant lead times.
• Project financings can easily reach 15 to 20 years.
Project finance Contd.
• Project finance techniques are increasingly being
used by companies, government, banks &
financial institutions, and international agencies.
• Project finance is the long term financing of
infrastructure and industrial projects.
• Project finance is popular in hydro-power sector
because of abundance of resources in Nepal.
6.2 Capital Structure Planning
• Capital structure is defined as “how a company finances
by using different sources of fund”.
• Sources of financing are equity capital & debt capital.
• Equity capital consists of common stock, preferred
stock, and retained earnings.
• Debt capital consists of long-term loans, debentures, &
working capital advances.
• Debt-to-equity ratio gives an indication of riskiness of
project's financing.
Capital Structure Planning contd.
• More debt than equity indicates some risk of
insolvency (state of having less money than one
owes to pay).
• A healthy balance between risk & return is
considered to be the ideal form of capital structure.
• Capital structure decision involves a tradeoff between
risk and return to maximize market price per share.
Capital Structure Planning contd.
• Finance manager should plan an optimum capital
structure for the company.
• Optimum capital structure is one that maximizes market
value of firm.
• Capital structure should be planned generally keeping
in view of the interest of equity shareholders & financial
requirements of the company.
• Finance manager should aim at maximizing long-term
market price per share.
Capital Structure Planning contd.
Numerical Example 1:
Determine the earning per share (EPS) of a “XYZ Company’
which is planning to finance in a project, the composition of the
capital structure is as follows:
Option 1 Option 2
Ordinary
2 nos. @100 200 3 nos. @100 300
share
Preference
1 no. @100 (15% interest) 100 1 no. @100 (15% interest) 100
share
Loan (Loan @ 12% interest) 300 (Loan @ 12% interest) 200
Total 600 Total 600
Capital Structure Planning contd.
Solution of Numerical Example 1:
Option 1 Option 2
Earnings before Income and Tax (EBIT) 100.00 100.00
Less: Interest on Loan @12% of 300 = 36.00 - 36.00 - 24.00
Earnings after Income and before Tax (EAIBT) 64.00 76.00
Less: Tax @ 20% of (EAIBT) - 12.80 - 15.20
Earnings after Interest and Tax (EAI&T) 51.20 60.80
Less: Interest to Preference Share @15% of 100 = - 15.00 - 15.00
15.00
Shareholder’s Earnings 36.20 45.80
Earnings per Share 36.20÷2 = 18.10 45.80÷3= 15.27
= Shareholder’s Earnings ÷ Number of Share
Capital Structure Planning contd.
IOE exam 2070 Ashadh, Question No. 6:
• A project has total capital of Rs. 500,000 which consists
of 2,000 Shares @ Rs. 100; Rs. 150,000 Preference
Shares 18% interest, and remaining Loan @ 14%
interest.
• Earning before income and tax in a year is Rs. 100,000.
• Calculate EPS and book value of share, if tax rate is
25%.
Capital Structure Planning contd.
Solution: Given
Capital structure:
Ordinary Shares 2,000 @ Rs.100 = 200,000
Preference Shares (18% interest) = 150,000
Loan @ 14% interest = 150,000
Total capital = 500,000
EBIT = 100,000;
EPS=?;
Book value of share =?;
Tax rate = 25%
Capital Structure Planning contd.
Earnings before Income and Tax (EBIT) 100,000.00
Less: Interest on Loan @14% of 150,000 = 21,000 - 21,000.00
Earnings after Income and before Tax (EAIBT) 79,000.00
Less: Tax @ 25 % of 79,000.00 = 19,750 - 19,750.00
Earnings after Interest and Tax (EAI&T) 59,250.00
Less: Interest to Preference Share @18 % of 150,000 = 27,000.00 - 27,000.00
Shareholder’s Earnings 32,250.00
EPS = Shareholder’s Earnings ÷ Number of Share
16.13
= 32,250.00 ÷ 2,000 = Rs. 16.13
Book value of share = 100 + 16.13 = Rs. 116.13 116.13
6.3 Capital Budgeting Decision
Capital
• Capital relates to total funds employed in a project.
• It is important to plan & arrange cash flow properly.
• Capital refers to wealth in the form of money or property that
can be used to produce more wealth.
• Capital may be classified as equity capital and debt capital.
• Equity capital is owned and invested by individuals in a
business project in the hope of receiving a profit.
Capital Budgeting Decision contd.
• Debt capital is obtained from lenders for investment.
• Borrowers have to pay interest plus borrowed
money to the lenders.
• Capital at any time is found out by deducting
liabilities from assets.
• Capital or equity = Assets - Liabilities.
• Working capital = current assets - current liabilities.
Capital Budgeting Decision contd.
Assets
• Assets are economic resources owned by a company
with expectations to produce future benefits to the
company.
• Assets can be tangible and intangible.
• Tangible assets include land, buildings, equipment,
inventories, supplies, cash, account receivable etc.
• Intangible assets include goodwill, patient, copy rights
etc.
Capital Budgeting Decision contd.
Liabilities
• Liabilities are obligations of a business.
• Creditor’s claims are called liabilities.
• Liabilities reflects amount owed to others.
• Liabilities include accounts payable, note payable, interest
payable, salaries & wages etc..
• Account payable is a liability created by buying products or
services on credit.
• Note payable is a liability expressed by a written promise to make
future payment at a specific time.
Capital Budgeting Decision contd.
Working Capital
• Working capital may be defined as the excess of current
assets over current liabilities.
• Working capital is needed to run day-to-day operations of
a business.
• Current assets are those assets, which can normally be
converted into cash within a financial year.
• Current liabilities are claims of outsiders which is
expected to mature for payment within a financial year
like sundry creditors, bank overdraft, short-term loan etc.
Capital Budgeting Decision contd.
Budget: Budget (from French, bougette, purse) refers to a list of
all planned expenses & revenues.
• A budget is in reality a set of plan for future course of action.
Capital Budget: involve planning to acquire worthwhile projects.
• Such project requires large amount of fund & have long term
implication.
• It is generally prepared separately from operating budget.
Operational Budget: is concerned with day-to-day operating
activities of a business.
• It is prepared for a normal operating cycle of one year.
Capital Budgeting Decision contd.
Project Budget
• Project budget is the basis for fiscal control throughout the life of
project.
• Estimate and project budget differ.
• Estimate precedes & is the basis for the development of project
budget.
• Project budget may be higher or lower than the estimate.
• It should be submitted to & approved by management.
• It is used to monitor & control costs of project activities.
Capital Budgeting Decision contd.
Objectives of budget
• Budget provides yardstick to compare future results.
• Budget assists to plan & control earnings & expenditure.
• Budget act as a guide for management decisions.
• Budget help managers to better understand what the
company expects from them.
• Action can be taken if variations occur against budget.
Capital Budgeting Decision contd.
Capital Budgeting
• It may be defined as the financial planning or decision making
process in risks & uncertainty for the allocation of scarce financial
resources in the proposed long-term investment opportunities.
• It is a complex process which may be divided into six phases:
planning, analysis, selection, financing, implementation, & review
of proposed project.
• Investment decision of a company is known as capital budgeting.
• Capital is a very limited resource.
Capital Budgeting Decision contd.
Capital Budgeting contd.
• Management should carefully decide whether a particular project is
economically acceptable or worth undertaking with satisfactory cash
flows & rates of return.
• It is basically concerned with the justification of capital
expenditures.
• Capital expenditure decisions will have a far-reaching influence on
a project’s profitability for many years to come.
• Success or failure of a project depends upon capital planning &
budgeting.
• Capital expenditure decisions are the most important decisions
taken by a company.
End of Chapter
