TOPIC 5 PROJECT FINANCING
TOPIC 5 PROJECT FINANCING
V: PROJECT FINANCING
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:
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
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.
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
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.
■ 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.
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%.
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.
where
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
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.
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)
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
Before tax cost of debt(Kdb)=annual cost before tax: Average value of debt(AV)
The cost of preference capital which is perpetual is calculated by the following formula.
𝐷 𝐴𝑛𝑢𝑎𝑙𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
Cost of Preference capital Kp = 𝑁𝑃 or 𝑁𝑒𝑡𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠
Where
Net proceeds (NP) = Net amount realized from the issue of preference shares
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 𝐴𝑛𝑢𝑎𝑙𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
Cost of preference capital Kp = 𝑁𝑃 or 𝑁𝑒𝑡𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠
Annual dividend:
a)issued at par
Note: and c shall be worked out by the students under the guidance of the lecturer.
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
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.
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:
Average value
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.
Alteratively,
Kr=ke(1-t)(1-b)
T: tax rate
b: brokerage
Illustration
Solution: %
9
Less brokerage@2%on 9=0.18
Alternatively,
Kr=ke(1-tax rate)(1-brokerage)
=15(1-0.40)(1-0.02)
=15(0.6)(0.98)=8.82%
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
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.
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:
Solution: