Project Financing: Sources of Finance
Project Financing: Sources of Finance
PROJECT FINANCING
The allocation of financial resources to a project constitutes an obvious and basic
prerequisite for investment decisions, for project formulation and pre-investment
analysis, and for determining the cost of capital. In a feasibility study, the capital outlay
of a project can be appropriately determined only after plant capacity and location have
been decided, together with estimates of the costs of developed site, buildings and civil
works, technology and equipment.
Defining the financial requirements of a project at the operational stage in terms of
working capital is equally necessary. This can be determined once the estimates are
made of production costs, on the one hand, and sales and income, on the other. These
estimates should cover a period of time and be reflected in a cash flow analysis. Unless
both estimates are available and available resources are sufficient to meet the fund
requirements, both in terms of initial capital investment and working capital needs over
a period of time, it would not be prudent to proceed to the financing decision and
project implementation.
Sources of finance
A generally applied financing pattern for an industrial project is to cover the initial
capital investment by equity and long-term loans to varying extents, and to meet
working capital requirements by additional short-term and medium-term loans form
national banking sources.
Equity can be raised by issuing two types of shares: ordinary shares [common shares];
and preference shares. Preference shares usually carry a dividend at least partly
independent form profit, without, or with only limited voting rights. Preference shares
can be convertible into common shares. Preference shares can be cumulative or non-
cumulative, redeemable or non-redeemable. Dividend payment on ordinary shares with
full voting rights, however, depends on the profitable operation of the company.
Loan financing
It is easy for a sound project to obtain loans. The loan capital can be classified in
different forms: short-term, medium-term and long-term. For working capital purposes,
short and medium-term can be borrowed from commercial banks or supplier credits of
various forms; and long-term borrowings can be availed form national or international
development finance institutions.
Short-term loans are available against hypothecation or pledging of inventories. The
limits to which inventories are financed vary between 50 and 80 percent. Bank
borrowings for working capital can be arranged on a temporary basis. Working capital
funds should even be partly met out of long-term funds [equity and long-term loans],
since the largest portion of working capital is permanently tied in inventories.
Long-term loans
Loan financing is usually subject to certain regulations on the convertibility of shares
and declaration of dividends. Further certain ratios in the capital structure of the
company need to be maintained. Investment may also be financed partly by issues of
bonds and debentures.
An important source of finance is also available at government –to- government level.
This can take the form of general bilateral credit or tied credit, which may be related to
the purchase of machinery and equipment from a particular country.
Internal cash generation is also a source of finance [accumulated reserves] At the
operational stage.
Supplier credit
Imported machinery and spares can be availed on deferred-payment terms with
payments spread over to 6 to 10 years and even longer. Deferred payment terms are
available against bank guarantees.
Leasing
Leasing, as the borrowing of productive assets is called, requires usually a down
payment and the payment of an annual rent, the leasing fee. These assets are, however,
contained in the balance sheet of the lessor and not in the balance sheet of the
borrowing firm, the lessee. Therefore, leasing essentially represents a form of off-
balance sheet financing.
In the case of investment projects the problem is basically to decide which alternative
should be preferred, leasing or purchasing of capital assets. For the evaluation of the
two financing alternatives the discounted cash flow method should be applied. The
initial down payment, the current leasing fees and any additional payments under the
leasing agreements are then part of the cash outflows, replacing all initial investment
costs computed for the purchasing alternative.
If the investor has a choice between loan and leasing financing, he would compare the
discounted cash flow for both cash flows arrays to determine which alternative would
bring the higher yield [IRR, NPV].
Funds to finance leases may be obtained from independent leasing companies, banks,
insurance companies, pension funds, industrial development agencies and international
financing institutions.
Example of investment outlay and structure of finance
Item Funds
[thousand national currency units]
A. Investment Outlay
Fixed –Investment costs:
Land 80
Buildings 2900
Equipment 4000
Other 730
Total initial fixed investment 7710
B. Structure of Investment
Source:
Equity capital 3500
Supplier credit 2600
Commercial credit 3000
Total long-term capital 9100
Surplus [long-term capital] during construction 380
Start-up year:
Short-term finance [bank O/D] 400
Cash deficit [start-up year] [10]
Financing of net increase in assets [start-up year] [600]
Finance available 170
Cost of capital
Capital for financing of investment may be obtained from private and institutional
resources [banks, insurance companies, funds, etc.]. To obtain finance, an investor must
therefore pay a charge- the cost of capital or of finance- for the funds lent. This charge
comprises an interest rate, as well as fixed charges [commitment fee, charge on capital
not drawn, commission, etc.]. Interest is usually computed on the outstanding balance of
the corresponding liabilities of a firm, for example, interest payable on bank loan,
dividends payable on equity capital [such as preference shares] and interest payable on
current account.
The cost of equity capital for the proje3ct or firm is basically determined by the
minimum accumulated return expressed as the NPV of the future income of the
shareholders, and the minimum annual rate of return, expressed as the rate of return on
equity capital.
The debt service [interest and amortization] is fixed and legally binding for the firm, and
has to be paid even when the generation of cash is insufficient in certain years.
The various forms and sources of financing have different implications in terms of
impact on different projects and may even affect project formulation. Supplier credits
and other forms of medium-term credit, thigh initially advantageous in terms of
coverage of resource gaps at the initial stage, constitutes a heavy debt burden during
early years of production. Their incidence on production costs should be determined
and accounted for in the cash flow analysis. As such the national and international
financial institutions insist that recognized consultants should prepare the feasibility
study.
Public policy and regulations on financing
The hard core of the entrepreneurial decision in respect of financing is to choose
between equity raised through the sale of shares and that raised through payments by
the project sponsor. The extent of initial equity depends on the anticipated profitability
and alternative sources of capital participation all under the prevailing regulations on
financing and taxation norms.
When a developing country has a reasonably well-developed capital market, equity
funds can be raised through public issues of shares. Banks and other institutions dealing
in industrial finance usually underwrite such share issues. In some cases, specialized
financial institutions also participate in the equity financing and the participation may be
higher level or at lower level depending on the country’s regulations.
In considering foreign equity participation for the projects, it is necessary to get
government approval. In some countries such approval is not granted particularly to
non-priority sectors of investment. In some cases, in sectors involving large investments
or in projects with a great employment potential, foreign participation is welcomed.
Financing Institutions.
Most developing countries have established development-financing institutions, usually
called industrial finance corporations or industrial development banks. The institutions
have been set up at national and at state levels. Some of the national institutions
provide foreign currency loans, which are financed by international institutions, such as
the World Bank and its affiliates.
Various international financial institutions and funding facilities exist and finance is
available for the industries in developing countries. Some of these include World Bank,
International Development Association, International Finance corporation, the special
fund of the Organization of petroleum Exporting Countries, the Kuwait Fund for Arab
Economic and Social Development, and the International Investment Bank of the
Council for Mutual Economic Assistance, operate on a world-wide scale. Many of these
funds are provided on soft terms for infrastructure, which are pre requisites of successful
industrialization.
There are also institutions, which are operating on regional basis, such as the African
Development Bank, the Asian Development Bank, the European Investment bank and
the Inter-American Development Bank. Funds have been set up by the oil ex [porting
countries, such as the Arab Fund for Economic and Social Development and the Islamic
Development Bank. Bilateral institutions have been set up in most of the countries of the
Organization for Economic Cooperation and Development and, in some oil-exporting
countries, including Kuwait, the United Arab Emirates and Venezuela.
The roles of export financing and guaranteeing agencies are also pertinent in project
financing. The primary task of such agencies is to provide financial support of exports
from industrialized countries; only as a secondary task are they designed to help
developing countries. Commercial banks, including those in the Eurocurrency market
and the currency markets of the Association of South-East Asian Nations, are becoming
increasingly active in industrial development financing. However, they lend to only a few
developing countries.
In many developing countries, the availability of industrial finance in the form of
institutional finance and from other sources has grown substantially. As such the new
entrepreneurs can start industrial ventures with a small share of equity as low as 10-25
of the total finance needed.
The various sources of finance, flow of financial resources and the utilization of these
funds are presented in the following tables.
International Organizations
Industrial investment consultancy has long been one of the traditional tasks of
international organizations such as the United Nations, a number of its specialized
agencies, including UNIDO, the Food and Agriculture Organization of the UN [FAO] and
the International Labor Organization [ILO], as well as the World Bank. All of these
organizations provide the consultancy services required, either themselves, through
their own staff, or by using the services of national and international consulting firms
and consultants.