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TOPIC 5 PROJECT FINANCING

The document discusses project financing, detailing sources of both long-term and short-term finance, including retained earnings, bank borrowing, trade credit, and commercial papers. It also covers the cost of capital, defining it as the minimum return expected by investors and explaining how to compute it for various sources. Additionally, it provides formulas for calculating the cost of debt and preference share capital, emphasizing the importance of understanding these financial concepts for effective project management.
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0% found this document useful (0 votes)
6 views15 pages

TOPIC 5 PROJECT FINANCING

The document discusses project financing, detailing sources of both long-term and short-term finance, including retained earnings, bank borrowing, trade credit, and commercial papers. It also covers the cost of capital, defining it as the minimum return expected by investors and explaining how to compute it for various sources. Additionally, it provides formulas for calculating the cost of debt and preference share capital, emphasizing the importance of understanding these financial concepts for effective project management.
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CHAP.

V: PROJECT FINANCING

V.1 SOURCES OF PROJECT FINANCE


V.1.1 Introduction

Once the project budget has been estimated and approved the funds can be raised to run the
project.
In this stage the owner of the project will decide to use own funds, external funds or a
combination of both. Whatever source is preferred, a lot of calculation in terms of cost must be
done.
Before the calculations are seen, a look on the possible source of fund are explained below:

V.1.2 LONG TERM SOURCE OF FINANCE

a. A project can be financed by a short or long term source. The following are
the long term sources:

 Retained earnings
 Own finds from equity shares
 Bank borrowing
 Government sources
 Venture capital
1.Ordinary (equity) shares

Ordinary shares are issued to the owners of a company. They have a nominal
or 'face' value. The market value of a quoted company's shares bears no
relationship to their nominal value, except that when ordinary shares are
issued for cash, the issue price must be equal to or be more than the nominal
value of the shares.

2.Preference shares

Preference shares have a fixed percentage dividend before any dividend is


paid to the ordinary shareholders. As with ordinary shares a preference
dividend can only be paid if sufficient distributable profits are available,
although with 'cumulative' preference shares the right to an unpaid dividend
is carried forward to later years. The arrears of dividend on cumulative
preference shares must be paid before any dividend is paid to the ordinary
shareholders.
3.Retained earnings

For any company, the amount of earnings retained within the business has a
direct impact on the amount of dividends. Profit re-invested as retained
earnings is profit that could have been paid as a dividend.

A company must restrict its self-financing through retained profits because


shareholders should be paid a reasonable dividend, in line with realistic
expectations, even if the directors would rather keep the funds for re-
investing. At the same time, a company that is looking for extra funds will not
be expected by investors (such as banks) to pay generous dividends, nor over-
generous salaries to owner-directors.
4.Bank lending

Borrowings from banks are an important source of finance to companies.


Bank lending is still mainly short term, although medium-term lending is quite
common these days.

Short term lending may be in the form of overdraft, short-term loan

Medium-term loans are loans for a period of from three to ten years. The rate
of interest charged on medium-term bank lending to large companies will be
a set margin, with the size of the margin depending on the credit standing and
riskiness of the borrower

V.1.3 SHORT TERM SOURCES OF FINANCES


Sources of short-term funds have to be used (exclusively) for meeting the working capital
requirements only and not for financing fixed assets and for meeting the margin money for working
capital loans.
The various sources of short-term financing are as follows:
1. Trade Credit: Trade credit refers to the credit extended by the supplier of goods or services to
his/her customer in the normal course of business.
Advantages of Trade Credit:
The main advantages are:
 Easy availability when compared to other sources of finance (except financially weak
companies).
 Flexibility is another benefit, as the credit increases with the growth of the firm's sales.
 Informality as we have already seen that it is an automatic finance.
.
2. Accruals:Accrued expenses are those expenses which the company owes to the other persons
or organizations, but not yet due and not yet paid the amount. In other words, accruals represent
a liability that a firm has to pay for the services or goods, which it has already received. It is
spontaneous and interest-free sources of financing. Salaries, wages, interest and taxes are the
major constituents of accruals. Salaries and wages are usually paid on monthly and weekly
basis respectively. The amounts of salaries and wages have owed but not yet paid and shown
them as accrued salaries and wages on the balance sheet at the end of financial year.
.
3. Deferred Income: Deferred incomes are incomes received in advance by the firm for supply of
goods or services in future period. These income receipts increase the firm's liquidity and
constitute an important source of short-term source finance. These payments are not showed
as revenue till the supply of goods or services, but showed in the balance sheet as income
received in advance. Advance payment can be demanded by only firms having monopoly
power, great demand for its products and services and if the firm is manufacturing a special
product on a special order.
4. Commercial Papers (CPs): Commercial paper represents a short-term unsecured promissory
note issued by firms that have a fairly high credit (standing) rating. It was first introduced in
USA and it was an important money market instruments. CP is a source of short-term finance
to only large firms with sound financial position.
5. Public Deposits: Public deposits or term deposits are in the nature of unsecured deposits, have
been solicited by the firms (both large and small) from general public primarily for the purpose
of financing their working capital requirements.
6. Inter-Corporate Deposits (ICDs: A deposit made by one firm with another firm is known as
inter-corporate deposits (ICDs). Generally, these deposits are usually made for a short term
period.
7. Bank Finance
Commercial banks are the major source of working capital finance to industries and commerce.
Granting loan to business is one of their primary functions. Getting bank loan is not an easy task
since the lending bank office may ask number of questions about the prospective borrower's
financial position and
Forms of Bank Finances
Banks provide different types of tailored made loans that are suitable for specific needs of a firm.
The different types of forms of loans are: Loans, Overdrafts, Cash credits, Purchase or discounting
of bills, and Letter of Credit.
1. Loans: Loan in an advance is him: sum given to borrower against some security. Loan
amount is paid to the applicant in the form of cash or by credit to his/her account. In practice
the loan amount is paid to the customer by crediting his/her account. Interest will be charged
on the entire loan amount from the date the loan is sanctioned. Borrower can repay the loan
either in lump sum or in installments depending on conditions. Generally, working capital
loans will be granted for one-year period.
2. Overdrafts: Overdraft facility is an agreement between the borrower and the banker, where
the borrower is allowed to "withdraw funds in excess of the balance in his/her current accounts
up to a certain limit during a specified period.
3. Cash Credit: It is the most popular source of working capital finance in developed countries.
A cash credit facility is an arrangement where a bank permits a borrower to withdraw money
up to a sanctioned credit limit against tangible security or guarantees. Borrower does not
require to withdraw the total sanctioned credit at a time, rather, he can withdraw according to
his/her requirements and he can also repay the surplus cash in his cash credit account.
4. Purchasing or Discounting of Bills: Bills receivable arises out of sales transaction, where
the seller of goods draws the bill on the purchaser. Once the bill is accepted by the purchaser,
then the drawer (seller) of the bill can go to bank for discount or sale. The credit worthiness of
the drawer (seller) is satisfactory, and then bank purchases or discounts the bill and reduces
funds by way of crediting to customers account. The credited amount will be less than the bill
amount. At the end of maturity period of the bill, bank presents the bill to drawee (acceptor)
for payment. If the bill is discounted and dishonored by the drawee, then the customer (seller)
is liable to pay the bill amount and any other expenses incurred to bank.

8 Factoring
Banks provide working capital finance through financing receivables. A "Factor" is a financial
institution, which renders services relating to the management and financing of sundry debtors that
arises from credit sales. Factoring is a popular mechanism of managing, financing and collecting
receivables in developed countries like USA and UK, and it has spread over to a number of
countries.
Features of Factoring
The following are the salient features of the factoring arrangement:
 Factor selects the accounts of the receivables of his client and set up a credit limit, for each
account of receivables depending on safety, financial stability and credit worthiness;
 The factor takes the responsibility for collecting the accounts receivables selected by it;
 Factor advances money to the client against selected accounts that may be not-yet
collected and not-yet-due debts. Generally, the amount of money as advances to 70 per
cent to 80 per cent of the amount of the bills (debt). But factor charges interest on advances,
that usually is equal to or slight higher than the landing rate of commercial banks.
Advantages
The following advantages relating to the facility of factor:
1. Factor ensures certain pattern of cash-in-flows from credit sales;
2. Elimination of debt collection department, if it is continuous goes factoring;
Limitations
Apart from the services observe by factor, the arrangement suffers from some limitations:
1. Services would be provided on selective accounts basis and not for all accounts (debts);
2. The cost of factoring is higher and compared to other sources of short-term working capital
finance;
3. Factoring of debt may be perceived as an indication of financial weakness.
4. Reduces future sales due to strict collection policy of factor.
V.2 COST OF CAPITAL
A. COST OF CAPITAL

A.1.MEANING

The cost of capital is the minimum rate of return expected by investors. Solmon Ezra defines
cost of capital as the minimum required rate of earnings or the cut-off rate of capital
expenditures. The capital of a firm may consist of debt, preference share capital, retained
earnings and equity capital. Therefore, cost of capital of a firm is the weighted average cost of
these sources.

Cost of capital may also be defined as the cost of obtaining funds. It is also known as cut-off rate,
target rate or hurdle rate.

If the firm is unable to earn the cut-oof rate, the market value of its shares will come down. Hence,
cost of capital the is the minimum rate of return the firm is expected to earn so as to maintain
the market value of its shares.

A.2 COMPUTATION OF COST OF CAPITAL

Computation of overall cost of capital of a firm consists of the following steps:

■ computation of the cost of specific sources such as debentures, preferences capital and equity
capital.

■Computation of the weighted average cost of capital or the overall cost of capital.

COMPUTATION OF THE COST OF SPECIFIC SOURCES


I.COST OF DEBT

I.1Cost of irredeemable debt

Irredeemable debt( or perpetual debt) is the debt which is not redeemable during the life time of
the company.

The cost of debt is the interest rate payable on the debt.For example,G LTD issued 10% debentures
for FRW 10 lakhs. The before tax cost of debt is 10%.

Before tax cost of debt(Kdb)= Interest: Net Proceed (N.P)

a.When debt is issued at par, the N.P=Face value-Issue Expenses


b.When debt is issued at premium, the N.P=Face value +Premium-Issue Expenses

c.When debt is issued at discount, the N.P=Face value-discount-Issue Expenses.

In the computation of income tax ,when interest tax is allowed as deduction,a firm saves tax on
interest paid. As result after tax cost is lower than the before-tax cost of debt.

After –tax cost of debt(Kda)=(Interest –Tax saving):N.P.

where

N.P=Net Amount realized.

The after tax cost may also be calculated by the formula:

After –tax cost of debt(Kda)=Before tax cost(1-tax rate)

Illustration

DIDNA industries LTD issues 5000 12% debentures of FRW 100 each at par.The tax rate is
40%.Calculate before tax and after tax cost of debt.

solution

Before tax cost of debt(Kdb)= Interest:Net Proceed (N.P)

After –tax cost of debt(Kda)=(Interest –Tax saving):N.P.

Interest @ 12% on 500,000= 60,000

Less Tax saving@40% on 60,000= 24,000

Interest –Tax saving= 36,000

Net Procceds=FRW 100x5000shares=500,000

Before tax cost of debt =60,000:500,000=0.12or 12%

After tax cost of debt = 36000:500,000=0.072 or 7.2%

NOTE: In the computation of income tax ,interest is allowed as a deductible expense.Hence a firm
saves tax on interest paid. As result,the after tax cost is lower than before tax cost of debt.

More exercises will be given to be worked out by students


I.2.Cost of Redeemable debt

Redeemable debt refers to debt which is to be redeemed after the stipulated period.For example,it
may be repayable after 5 or 7 or 10 years
The before tax cost of redeemable is calculated as under:

Before tax cost of debt(Kdb)=annual cost before tax: Average value of debt(AV)

Annual cost before tax is calculated as under:

Interest per annum …………..

Add issue expenses ,p.a ……………..

Add discount on issue, amortised p.a ………….....

(when issued at discount)

Add premium on redemption,amortised p.a …………………..

(when redeemable at premium)

Less premium on issue ,p.a ……………………

(when issued at premium)

Annual cost before tax ………………

AV=(NP+RV):2

The after tax cost of debt (Kda)=annual cost after tax: average value of debt
Illustration

A firm issues debentures of 100,000FRW and realize 98000FRW after allowing 2% to the
brokers.The debentures carry an interest rate of 10%.The debentures are due for maturity at the
end of the 10th year. Calculate the effective cost of debt before tax.

Solution

Annual cost before tax

Before tax cost of debt(Kdb)=annual cost before tax: Average value of debt(AV)

Interest @10% on 100,000= 10,000

Add commission p.a=2% on100,000=2000:10= 200

Annual cost before tax= 10,200


Average value of debt

Issue price 100,000

Less commission 2% 2000

Net proceed 98000

Redemption value(RV) 100,000

Average value=(NP+NV):2 =(98000+100,000):2=99,000

Before tax cost=10,200:99,000=0.103 or 10.3%

II. COST OF PREFERENCE SHARECAPITAL


A fixed rate of divided is payable on preference shares. The dividend is payable at the discretion
of directors. Yet preference dividend is regularly paid by companies when they earn profits.

II.1Cost of irredeemable preference capital

The cost of preference capital which is perpetual is calculated by the following formula.
𝐷 𝐴𝑛⁥𝑢𝑎𝑙𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
Cost of Preference capital Kp = 𝑁𝑃 or 𝑁𝑒𝑡𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠

Where

Annual dividend = Annual preference dividend payable

Net proceeds (NP) = Net amount realized from the issue of preference shares

a) When preference shares are issued at par:


NP= Face value – Issue expenses
b) When preference shares are issued at a premium:
NP= Face value + Premium- Issue expenses
c) When preference shares are issued at a discount:
NP = face value – Discount – Issue expenses

Preference dividend is not allowed as a deduction in the computation of income tax. Hence before
tax cost and after tax cost are the same.

Illustration:

A company issues 20,000 10% preference shares of 100 each.The issue expenses were FRW 2
per share. calculate the cost of preference sharecapital if the shares are issued
a)at par b)at premium of 10% c) at discount of 5%

Solution:
𝐷 𝐴𝑛⁥𝑢𝑎𝑙𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
Cost of preference capital Kp = 𝑁𝑃 or 𝑁𝑒𝑡𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠

Annual dividend:

Face value of preference share capital=100x20,000=2,000,000FRW

Annual dividend @10%= 200,000FRW

a)issued at par

Face value= 2,000,000

Less issue expenses FRW 2x20,000= 40,000

Net proceed (N.P) 1,960,000

Cost of preference sharecapital=200,000:1960,000=0.102 or 10.2%

Note: and c shall be worked out by the students under the guidance of the lecturer.

II.2.Cost of Redeemable preference Share capital (RPS)

Preference shares which are to be redeemed after the expiry of the stipulated period are known as
redeemable preference shares.
𝐴𝑛𝑛𝑢𝑎𝑙𝑐𝑜𝑠𝑡
The cost of Redeemable preference shares (RPS)= 𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑣𝑎𝑙𝑢𝑒𝑜𝑓𝑅𝑃𝑆

ANNUAL COST

Preference dividend p.a ……………..

Add. Issue expenses, amortized p.a …………………….

Add discount on issue, amortized p.a ……………....

(when issued at a discount)

Add : premium on redemption, amortized p.a ……………….

(when redeemable at a premium)


Less.Premium p.a …………………………….

(When issued at premium)

Annual cost ……………………

Average value of RPS

Average value is the average of net proceeds (NP) of the issue and the redemption value (RV)
𝑁𝑃+𝑅𝑉
Average value =
2

NOTE: To calculate annual costs, the issue expenses, discount on issue, premium of redemption
and premium on issue are amortized over the tenure of the preference shares.

Net proceeds (NP)

a) When RPS is issued at par: NP = Face value – Issue expenses


b) When RPS is issued at a premium: NP= Face value + premium – Issue expenses
c) When RPS is issued at a discount: NP= Face value – Discount – issue expense

Illustration:

NIXON LTD issues 10,000 9% of FRW 100 each. The share are redeemable after 10 years
and at premium of 5%.floatation cost are 2%. On face value .Calculate the effective cost
of preference share capital.

Solution:
𝐴𝑛𝑛𝑢𝑎𝑙𝑐𝑜𝑠𝑡
The cost of Redeemable preference shares (RPS)= 𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑣𝑎𝑙𝑢𝑒𝑜𝑓𝑅𝑃𝑆

Annual cost:

Face value 100x10,000=1,000,000FRW

Preference dividend 9% on 1,000,000= 90,000FRW

Add. Floatation costs 2%on 1,000,000= 20,000

Floatation cost p.a=2000:10= 2000FRW


Add. Premium on redemption5% of 1,000,000=50,000

Premium p.a=50,000:10= 5000FRW

ANNULA COST= 97,000FRW

Average value

Issue price= 1,000,000

Less Floatation cost 20,000

Net proceeds 980,000

Face value 1,000,000

Add. Premium on redemption 50,000

Redemption value (RV): 1,050.000

AVERAGE VALUE=(NP+NV):2=(980,000+1,050,000):2=1,015,000 FRW

Cost of redeemable preference sharecapital=9,700,000:1,015,000=0.9557 or 9.56%

.COST OF RETAINED EARNINGS

All the profits earned by a company are not distributed as dividends to shareholders.
Generally companies retain a portion of thr earnings for use in business.This is called
retained earnings.

The company has not to pay any dividend to the retained earnings.Hence it is argued
that retained earning do not have any cost.This view is not correct.If the amount
retained by the company had been distributed to shareholders,they would have
invested the amount elsewhere and earned some return.As the earning have been
retained by the company, the shareholders have foregone the return. Therefore
retained earnings do have a cost.The cost of retained earning is the return forgone
by the shareholders. It is thus the opportunity cost of dividends foregone by
shareholders. It is to be noted that shareholders can not invest the entire dividend
income. They have to pay income tax on dividends. Further they have to pay
brokerage for purchase of securities(for investing the afte. tax dividend) .Therfore
adjustments are done for brokerage and tax to compute the cost of retained earnings.

The cost for retained earnings may be ascertained as follow:

a.cost of equity capital(ke) ..……………

b.less tax on cost of equity ……………

c.less brokerage(% on a-b)

Cost of retained earnings(kr) ……….

Alteratively,

Kr=ke(1-t)(1-b)

Where kr: cost of retained earnings

Ke: cost of equity capital

T: tax rate

b: brokerage

Illustration

A company ‘s cost of equity capital(ke) is 15%.The average tax rate of shaereholders


is 40% and the brokerage cost for purchase of securities is 2%.Calculate the cost of
retained earnings

Solution: %

Cost of equity capital(ke)= 15

Less tax at 40% on 15= 6

9
Less brokerage@2%on 9=0.18

Cost of retained earnings=8.82

Alternatively,

Kr=ke(1-tax rate)(1-brokerage)

=15(1-0.40)(1-0.02)

=15(0.6)(0.98)=8.82%

WEIGHTED AVERAGE COST OF CAPITAL(WACC)

The weighted average cost of capital is very important in financial decision making.
WACC is the the weighted average cost of different sources of finances.It is also
known as composite cost of capital or overall cost of capital

The steps for calculations of WACC are:

1.After tax cost is relevant in financial decision making .Therefore the after tax cost
of each of the sources(x ) of finance is to be ascertained.

2.The proportion of each source in the total capital(w) is to be determined.The


proportions are used as weghts to find out WACC.

3.The cost f each source(x) is multiplied by the appropriate weight (x) x(w)

4.The total of the weighted costs of each source is the weighted average cost of
capital

(WAAC= ∑X.W )

Illustration:The capital structure and after tax coast of different sources of funds
are given below:

Sources of funds Amount Proportion to After tax cost %


in FRW total
Equity share capital 720,0000. 0.30 15
Preferences shares capital 480,000 0.20 10
Debentures 600,000 0.25 8
Retained Earnings 600,000 0.25 14

You are required to compute the WACC

Solution:

Sources of funds Proportion After tax cost % Weighted cost


to total(W) (x) %( W).(X)
Equity share capital 0.30 15 4.5
Preferences shares capital 0.20 10 2
Debentures 0.25 8 2
Retained Earnings 0.25 14 3.5
weighted average cost of capital (wacc) 12

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