What is Project Financing?

Project Financing is a long-term, zero or limited recourse financing solution that is

available to a borrower against the rights, assets, and interests related to the concerned
project.

If you are planning to start an industrial, infrastructure, or public services project and
need funds for the same, Project Financing might be the answer that you are looking
for.
The repayment of this loan can be done using the cash flow generated once the project
is complete instead of the balance sheets of the sponsors. In case the borrower fails to
comply with the terms of the loan, the lender is entitled to take control of the project.
Additionally, financial companies can earn better margins if a company avails this
scheme while partially shifting the associated project risks. Therefore, this type loan
scheme is highly favoured by sponsors, companies, and lenders alike.
In order to bridge the gap between sponsors and lenders, an intermediary is formed
namely Special Purpose Vehicle (SPV). The main role of the SPV is to supervise the
fund procurement and management to ensure that the project assets do not succumb to
the aftereffects of project failure. Before a lender decides to finance a project, it is also
important that all the risks that might affect the project are identified and allocated to
avoid any future complication.

What Is Special Purpose Vehicle and Why Is It Necessary?

During Project Financing, a Special Purpose Vehicle (SPV) is appointed to ensure that
the project financials are managed properly to avoid non-performance of assets due to
project failure. Since this entity is established especially for the project, the only asset it
has is the project. The appointment of SPV guarantees the lenders of the sponsors’
commitment by ensuring that the project is financially stable.

Key Features of Project Financing

Since a project deals with huge amount funds, it is important that you learn about this
structured financial scheme. Below mentioned are the key features of Project Financing:
 Capital Intensive Financing Scheme: Project Financing is ideal for ventures requiring
huge amount of equity and debt, and is usually implemented in developing countries as
it leads to economic growth of the country. Being more expensive than corporate loans,
this financing scheme drives costs higher while reducing liquidity. Additionally, the
projects under this plan commonly carry Emerging Market Risk and Political Risk. To
insure the project against these risks, the project also has to pay expensive premiums.
 Risk Allocation: Under this financial plan, some of the risks associated with the project
is shifted towards the lender. Therefore, sponsors prefer to avail this financing scheme
since it helps them mitigate some of the risk. On the other hand, lenders can receive
better credit margin with Project Financing.
 Multiple Participants Applicable: As Project Financing often concerns a large-scale
project, it is possible to allocate numerous parties in the project to take care of its
various aspects. This helps in the seamless operation of the entire process.
 Asset Ownership is Decided at the Completion of Project: The Special Purpose
Vehicle is responsible to overview the proceedings of the project while monitoring the
assets related to the project. Once the project is completed, the project ownership goes
to the concerned entity as determined by the terms of the loan.
 Zero or Limited Recourse Financing Solution: Since the borrower does not have
ownership of the project until its completion, the lenders do not have to waste time or
resources evaluating the assets and credibility of the borrower. Instead, the lender can
focus on the feasibility of the project. The financial services company can opt for limited
recourse from the sponsors if it deduces that the project might not be able to generate
enough cash flow to repay the loan after completion.
 Loan Repayment With Project Cash Flow: According to the terms of the loan in
Project Financing, the excess cash flow received by the project should be used to pay
off the outstanding debt received by the borrower. As the debt is gradually paid off, this
will reduce the risk exposure of financial services company.
 Better Tax Treatment: If Project Financing is implemented, the project and/or the
sponsors can receive the benefit of better tax treatment. Therefore, this structured
financing solution is preferred by sponsors to receive funds for long-term projects.
 Sponsor Credit Has No Impact on Project: While this long-term financing plan
maximises the leverage of a project, it also ensures that the credit standings of the
sponsor has no negative impact on the project. Due to this reason, the credit risk of the
project is often better than the credit standings of the sponsor.

What Are the Various Stages of Project Financing?

1. Pre-Financing Stage
 Identification of the Project Plan - This process includes identifying the strategic
plan of the project and analysing whether its plausible or not. In order to ensure that
the project plan is in line with the goals of the financial services company, it is
crucial for the lender to perform this step.
 Recognising and Minimising the Risk - Risk management is one of the key steps
that should be focused on before the project financing venture begins. Before
investing, the lender has every right to check if the project has enough available
resources to avoid any future risks.
 Checking Project Feasibility - Before a lender decides to invest on a project, it is
important to check if the concerned project is financially and technically feasible by
analysing all the associated factors.

2. Financing Stage
Being the most crucial part of Project Financing, this step is further sub-categorised
into the following:
  Arrangement of Finances - In order to take care of the finances related to the
project, the sponsor needs to acquire equity or loan from a financial services
organisation whose goals are aligned to that of the project
 Loan or Equity Negotiation - During this step, the borrower and lender negotiate
the loan amount and come to a unanimous decision regarding the same.
 Documentation and Verification - In this step, the terms of the loan are mutually
decided and documented keeping the policies of the project in mind.
 Payment - Once the loan documentation is done, the borrower receives the funds
as agreed previously to carry out the operations of the project.

3. Post-Financing Stage
 Timely Project Monitoring - As the project commences, it is the job of the project
manager to monitor the project at regular intervals.
 Project Closure - This step signifies the end of the project.
 Loan Repayment - After the project has ended, it is imperative to keep track of the
cash flow from its operations as these funds will be, then, utilised to repay the loan
taken to finance the project.

Types of Sponsors in Project Financing

In order to determine the objective of the project and the risks related to it, it is important
to know the type of sponsor associated with the project. Broadly categorised, there are
four types of project sponsors involved in a Project Financing venture:
 Industrial sponsor - These type of sponsors are usually aligned to an upstream or
downstream business in some way.
 Public sponsor - The main motive of these sponsors is public service and are usually
associated with the government or a municipal corporation.
 Contractual sponsor - The sponsors who are a key player in the development and
running of plants are Contractual sponsors.
 Financial sponsor - These type of sponsors often partake in project finance initiatives
and invest in deals with a sizeable amount of return.

Conclusion
Project Financing is a long-term, non-recourse or limited recourse financing scheme
that is used to fund massive projects which can be repaid using the project cash flow
obtained after the completion of the project. This scheme offers financial aid off balance
sheet, therefore, the credit of the shareholder and Government contracting authority
does not get affected. In Project Financing, multiple participants are allowed to handle
the project while the ownership of the project is entitled according to the terms of the
loan only after the project is completed. This financial scheme offers better credit margin
to lenders while shifting some of the risk from the sponsors to the lenders.
As the Indian Government continues to investment on the infrastructure of the country, it
is expected that there will be massive developments in future in terms of power,
transportation, bridges, dams etc. Most of these projects will be using the Public Private
 Partnership (PPP) method indicating a rise in Project Financing during the upcoming
years. This entire cycle will further help improve the economic condition of India.

FAQs
1. What are the main features of non-recourse/recourse financing?
Some of the main features of non-recourse/recourse financing are mentioned below:
 Government guarantee may be provided.
 Retention and Use of Trust
 Financing via Special Purpose Vehicles
2. What are the main features of non-infrastructure financing?
The main features of Non-Infrastructure Financing are mentioned below:
 The loan can be availed in foreign currency.
 The proposals are disposed of fast.
 Depending on the bank, the repayment tenure may be up to 84 months.
 Funds are provided for setting up industrial/manufacturing units.
 Loans are provided for the expansion of existing units.
3. What are the main characteristics of Infrastructure Financing?
The main characteristics of Infrastructure Financing are mentioned below:
 You may be able to borrow in foreign currency.
 The capital costs are large.
 The revenues can only be in local currency.
 Any services that are provided cannot be traded.
 It is not easy to transfer the assets.
 The gestation periods are long.
 What is Project Finance?
Project Finance deals with financial aspects related to a particular
project that involves analyzing the feasibility of a project and its
funding requirements on the basis of the cash flows that the project is
expected to generate, if undertaken, over the years.

 Large projects, especially related to infrastructure, oil, and gas, or

public utility, are highly capital intensive and require funding. Project
finance acts as a means to fund these projects. It involves considering
a project on a standalone basis. The project themselves are treated as
financial entities (Special Purpose Vehicles or SPVs).
 It is so because the financing of these projects usually remains off-
balance-sheet of the company that is undertaking the project. It is
done in order to reduce the risks involved and their possible impact
on the company’s existing balance sheets.
 Thus, all the liabilities of the project are paid off only from the cash
flows generated by the project. Assets owned by the parent
company can’t be used to pay off these debts.

Key Features of Project Finance

The following are key features –

1. Risk Sharing: The company shares the risks associated with the

project failure with the other participating entities by keeping the
project off the balance sheet.
2. Involvement of Multiple Parties: As the projects are large and
capital extensive, multiple parties often provide capital in the form of
debt or equity.
3. Better Management: As the whole project is a different entity in itself,
often, a dedicated team is assigned to look after the completion of the
project, which results in better efficiency and output.

Sponsors in Project Finance

Sponsors associated with a special purpose vehicle can be of following
types:

1. Industrial: These are mainly those whose business gets impacted in

some way (positive impact) with the project been executed.
2. Public: These include the sponsors that have the public interest in
mind. These can be associated with government or other cooperative
societies.
3. Contractual: These sponsors are mainly involved in the development,
operations, and maintenance of the project.
4. Financial: These include the sponsors that participate in project
financing, looking for high returns.

Different Stages of Project

Financing
The following are different stages –
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#1 – Pre Finance
 Identification of the project to undertake to depend upon business
requirements and industry trends;
 Identifying the risks involved if the project is undertaken (both internal
and external);
 Investigating the feasibility of the project, both technical and financial,
on the basis of resource requirements;

#2 – Finance
 Identification and reach out to possible stakeholders to meet financial
needs.
 Negotiate the terms and conditions associated with the debt or equity
from stakeholders.
 Receiving the funds from the stakeholders;

#3 – Post Finance
 Monitoring the project cycle and milestones associated with the
execution;
 Completing the project before the deadline;
 Repayment of the loans through the cash flows generated from the
project;

Risks Involved
The following are risks involved –

 Costs of Project: During the financial and technical analysis of a

project, a certain cost of raw materials would have been assumed. If
the costs exceed the assumptions, it will get difficult to repay the
capital.
 Timeliness: Missing the deadlines associated with the project can
result in penalties.
 Performance: Even if the project gets completed on time, it is
necessary that it meets the expectations so that it can generate
expected cash flows.
 Political Risks: Government related projects always have
huge political risks involved as a change in political policies can
impact funding, feasibility, requirements of the project.
 Currency Exchange: If the lenders are not local, the capital will
involve exchange rate risks as interest payable can go up.
 Why is SPV Necessary for Project
Finance?
SPVs are beneficial from the perspective of both the lenders as well as
sponsors:

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 Sponsors: As the project is off the balance sheet of the sponsors, it

mitigates the risks associated with project failure; that is, if the project
fails, creditors will not have any right on the assets of the sponsors.
 Lenders: It is beneficial for the lenders, too, because risks that are
associated with the sponsors’ main business do not get transferred to
the project.

Advantages
 As the SPV is a different entity altogether, it can raise as much debt as
the project needs, depending upon expected cash flows, irrespective
of the credit rating of the sponsors.
 Project Financing helps to reduce the risks associated with the project
as well, for both lenders and sponsors, as discussed in the benefits of
SPV.
 Project Financing provides the companies with an opportunity to
come together for a common objective. For example, an upstream oil
and gas company can form an SPV with a company having oil storage
tanks to form a pipeline that connects both.

Disadvantages
Some of the disadvantages are as follows.

 A simple loan facility is easier to avail as well as to manage in accounts

books than project financing because an SPV often involves multiple
entities, and they all have to agree on multiple decisions related to
financing, operating, execution, etc. which makes the project financing
complex.
 Incorporating an SPV can be a tedious process in terms of
compliances, regulations, documentation, etc. because its functions
and business requirements differ from other corporate entities.
 Considering the complexities involve with the funding and business
conduct of the SPVs, there might be the requirements of experts and
professionals like investment bankers, which can be costly.

Limitations
The major limitation of project financing is associated with its usage
for small projects. Considering the disadvantages of project financing
discussed above, such as the costs, complexities, documentations, it
may not be feasible to opt for project financing for small scale projects
Sources of finance. Project finance may come from a variety of sources. The main sources include equity,
debt and government grants. Financing from these alternative sources have important implications on project's
overall cost, cash flow, ultimate liability and claims to project incomes and assets.

 What are equity and debt?

Equity refers to capital invested by sponsor(s) of the PPP project and others.

Debt refers to borrowed capital from banks and other financial institutions. It has fixed maturity and a fixed rate
of interest is paid on the principal.

Equity is provided by project sponsors, government, third party private investors, and internally generated
cash. Equity providers require a rate of return target, which is higher than the interest rate of debt financing.
This is to compensate the higher risks taken by equity investors as they have junior claim to income and assets
of the project.

Lenders of debt capital have senior claim on income and assets of the project. Generally, debt finance makes
up the major share of investment needs (usually about 70 to 90 per cent) in PPP projects. The common forms
of debt are:

 Commercial loan
 Bridge finance
 Bonds and other debt instruments (for borrowing from the capital market)
 Subordinate loans

Commercial loans are funds lent by commercial banks and other financial institutions and are usually the main
source of debt financing. Bridge financing is a short-term financing arrangement (e.g., for the construction
period or for an initial period) which is generally used until a long-term financing arrangement can be
implemented. Bonds are long-term interest bearing debt instruments purchased either through the capital
markets or through private placement (which means direct sale to the purchaser, generally an institutional
investor - see below). Subordinate loans are similar to commercial loans but they are secondary or
subordinate to commercial loans in their claim on income and assets of the project.

The other sources of project finance include grants from various sources, supplier's credit, etc. Government
grants can be made available to make PPP projects commercially viable, to reduce the financial risks of private
investors, and to achieve socially desirable objectives such as to induce economic growth in lagging or
disadvantaged areas. Many governments have established formal mechanisms for the award of grants to PPP
projects. Where grants are available, depending on government policy they may cover 10 to 40 per cent of the
total project investment. 

 Example: Viability gap funding in India

The viability gap funding scheme of the Government of India is an example of an institutional mechanism
for providing financial support to public-private partnerships in infrastructure. A grant, one-time or deferred, is
provided under this scheme with the objective of making projects commercially viable.
The viability gap funding can take various forms including capital grants, subordinated loans, operation and
maintenance support grants, and interest subsidies. A mix of capital and revenue support may also be
considered.

A special cell within the Ministry of Finance manages the special fund, which receives annual budget
allocations from the Government. Implementing agencies can request funding support from the fund according
to some established criteria. In case of projects being implemented at the state level, matching grants are
expected from the state government

The main providers of finance for the PPP project are:

 Equity investment from project promoters and individual investors

 National and foreign commercial banks and financial institutions
 Institutional investors
 Capital markets
 International financial institutions

Loans provided by national and foreign commercial banks and other financial institutions generally form the
major part of the debt capital for infrastructure projects. The rate of interest could be either fixed or floating.
Loans are normally provided for a term shorter than the project period. Often two or more banks and financial
institutions participate in making a loan to a borrower known as syndicated loan. Refinancing of the loan is
required when the loans are provided for a maturity period shorter than the project period.

In addition to commercial banks, international and regional financial institutions such as the World Bank or the
Asian Development Bank often provide loans, guarantees or equity to privately financed infrastructure projects.

Institutional investors such as investment funds, insurance companies, mutual funds, or pension funds
typically have large sums available for long-term investment and could represent an important source of
funding for infrastructure projects either through private placement or via bonds purchases.

When investors and financiers consider financing a project, they carry out extensive due diligence work taking
into account technical, financial, legal and other aspects of the PPP deal. This due diligence is intended to
ensure that the project company's (or SPV's) business plan is robust and the company has the capacity to
deliver on the PPP contract.

The financing arrangement for a large project can be quite complex. For such a project the required finance
typically comes from a large number of providers. This is illustrated by the case of a hydropower project in Lao
PDR, see next box.

 Financing arrangement for a large project: hydropower project in

Lao PDR
Figure 9
Source: Presentation by the Asian Development Bank at a seminar organized by the Asian Development Bank
Institute on 19-22 November 2007, Tokyo, Japan, and other sources.
 Sources of project financing will depend on the structuring of the project (which is heavily
impacted by project risks). There are many financial products in the market to pay for
construction costs. The cost (interest rates and fees) of each financial product will depend on the
type of asset and risk profile.

Private Debt

 Debt that is raised by investment banks

 Cheaper cost of capital than equity financing since debt holders will be repaid first

Public Debt

 Debt that is raised by the government under advisement of an investment bank or advisor

 Cheapest cost of capital since it is a government sponsored program used to spur

infrastructure development

Equity Financing

 Equity that is raised by a developer or private equity fund

 Highest cost of capital since equity is repaid last and rates of return must reflect the riskiness
of investment
Below are the most common types of private debt, public debt, and equity financing in the US
infrastructure market.
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Private Debt
Bank Debt

Project finance loans provided by commercial banks. Tenors range between 5-15 years.
Significant in-house expertise.

Capital Markets/Taxable Bonds

Capital Markets consist of suppliers of funds and users of funds engaging in the trade of long-
term debt and equity. Primary markets consist of those engaged in the issuance of new equity
stock and bond issuances, while secondary markets trade existing securities.
Institutional Investors/Private Placement

Private Placement Bonds placed directly with institutional investors (mainly insurance
companies). Flexibility in structuring financing solution.

Public Debt
TIFIA

USDOT credit program that finances up to 33% (49%) of project capital costs. Long tenor,
principal/interest holiday, subsidized interest rate and flexible repayment terms.

Capital Markets/Private Activity Bonds

Federal program that authorizes issuance of tax exempt bonds for the financing of capital costs
of transportation projects. Financing terms based on project economics, capital markets, credit
rating and IRS rules.

Equity Financing
Subordinated Debt

Loan or security that ranks below other loans or securities in regards to the cash flow waterfall
and claims on assets or earnings in the case of liquidation.

Shareholder Loans

Part of shareholder funding can be provided in the form of shareholder loans. Allows for lower
cost of capital

Bridge Loans

A bridge loan is a short-term financing tool used to provide immediate cash flow until a long-
term financing option can be arranged or existing obligation is extinguished

Strategic and passive equity

Funds contributed by the shareholders of the development entity. Repayment after O&M and
debt service. Required by lenders to ensure capital at risk. Ranges between 5-50% of private
financing, depending on project.
Chapter objectives
This chapter is intended to provide:

 An introduction to the different sources of finance available to management, both internal and
external

 An overview of the advantages and disadvantages of the different sources of funds

 An understanding of the factors governing the choice between different sources of funds.

Structure of the chapter

This final chapter starts by looking at the various forms of "shares" as a means to raise new
capital and retained earnings as another source. However, whilst these may be "traditional"
ways of raising funds, they are by no means the only ones. There are many more sources
available to companies who do not wish to become "public" by means of share issues. These
alternatives include bank borrowing, government assistance, venture capital and franchising. All
have their own advantages and disadvantages and degrees of risk attached.

Sources of funds
A company might raise new funds from the following sources:

 The capital markets:

i) new share issues, for example, by companies acquiring a stock market listing for the first time

ii) rights issues

 Loan stock
 Retained earnings
 Bank borrowing
 Government sources
 Business expansion scheme funds
 Venture capital
 Franchising.

Ordinary (equity) shares

Ordinary shares are issued to the owners of a company. They have a nominal or 'face' value,
typically of $1 or 50 cents. 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.

Deferred ordinary shares

are a form of ordinary shares, which are entitled to a dividend only after a certain date or if
profits rise above a certain amount. Voting rights might also differ from those attached to other
ordinary shares.

Ordinary shareholders put funds into their company:

a) by paying for a new issue of shares

b) through retained profits.

Simply retaining profits, instead of paying them out in the form of dividends, offers an important,
simple low-cost source of finance, although this method may not provide enough funds, for
example, if the firm is seeking to grow.

A new issue of shares might be made in a variety of different circumstances:

a) The company might want to raise more cash. If it issues ordinary shares for cash, should the
shares be issued pro rata to existing shareholders, so that control or ownership of the company
is not affected? If, for example, a company with 200,000 ordinary shares in issue decides to
issue 50,000 new shares to raise cash, should it offer the new shares to existing shareholders,
or should it sell them to new shareholders instead?
i) If a company sells the new shares to existing shareholders in proportion to their existing
shareholding in the company, we have a rights issue. In the example above, the 50,000 shares
would be issued as a one-in-four rights issue, by offering shareholders one new share for every
four shares they currently hold.

ii) If the number of new shares being issued is small compared to the number of shares already
in issue, it might be decided instead to sell them to new shareholders, since ownership of the
company would only be minimally affected.

b) The company might want to issue shares partly to raise cash, but more importantly to float' its
shares on a stick exchange.

c) The company might issue new shares to the shareholders of another company, in order to
take it over.

New shares issues

A company seeking to obtain additional equity funds may be:

a) an unquoted company wishing to obtain a Stock Exchange quotation

b) an unquoted company wishing to issue new shares, but without obtaining a Stock Exchange
quotation

c) a company which is already listed on the Stock Exchange wishing to issue additional new
shares.

The methods by which an unquoted company can obtain a quotation on the stock market are:
a) an offer for sale
b) a prospectus issue
c) a placing
d) an introduction.

Offers for sale:

An offer for sale is a means of selling the shares of a company to the public.

a) An unquoted company may issue shares, and then sell them on the Stock Exchange, to raise
cash for the company. All the shares in the company, not just the new ones, would then become
marketable.

b) Shareholders in an unquoted company may sell some of their existing shares to the general
public. When this occurs, the company is not raising any new funds, but just providing a wider
market for its existing shares (all of which would become marketable), and giving existing
shareholders the chance to cash in some or all of their investment in their company.

When companies 'go public' for the first time, a 'large' issue will probably take the form of an
offer for sale. A smaller issue is more likely to be a placing, since the amount to be raised can
be obtained more cheaply if the issuing house or other sponsoring firm approaches selected
institutional investors privately.

Rights issues

A rights issue provides a way of raising new share capital by means of an offer to existing
shareholders, inviting them to subscribe cash for new shares in proportion to their existing
holdings.

For example, a rights issue on a one-for-four basis at 280c per share would mean that a
company is inviting its existing shareholders to subscribe for one new share for every four
shares they hold, at a price of 280c per new share.

A company making a rights issue must set a price which is low enough to secure the
acceptance of shareholders, who are being asked to provide extra funds, but not too low, so as
to avoid excessive dilution of the earnings per share.

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.

From the company's point of view, preference shares are advantageous in that:

 Dividends do not have to be paid in a year in which profits are poor, while this is not the case
with interest payments on long term debt (loans or debentures).
 Since they do not carry voting rights, preference shares avoid diluting the control of existing
shareholders while an issue of equity shares would not.

 Unless they are redeemable, issuing preference shares will lower the company's gearing.
Redeemable preference shares are normally treated as debt when gearing is calculated.

 The issue of preference shares does not restrict the company's borrowing power, at least in
the sense that preference share capital is not secured against assets in the business.

 The non-payment of dividend does not give the preference shareholders the right to appoint a
receiver, a right which is normally given to debenture holders.

However, dividend payments on preference shares are not tax deductible in the way that
interest payments on debt are. Furthermore, for preference shares to be attractive to investors,
the level of payment needs to be higher than for interest on debt to compensate for the
additional risks.

For the investor, preference shares are less attractive than loan stock because:

 they cannot be secured on the company's assets

 the dividend yield traditionally offered on preference dividends has been much too low to
provide an attractive investment compared with the interest yields on loan stock in view of the
additional risk involved.

Loan stock
Loan stock is long-term debt capital raised by a company for which interest is paid, usually half
yearly and at a fixed rate. Holders of loan stock are therefore long-term creditors of the
company.

Loan stock has a nominal value, which is the debt owed by the company, and interest is paid at
a stated "coupon yield" on this amount. For example, if a company issues 10% loan stocky the
coupon yield will be 10% of the nominal value of the stock, so that $100 of stock will receive $10
interest each year. The rate quoted is the gross rate, before tax.

Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt
incurred by a company, normally containing provisions about the payment of interest and the
eventual repayment of capital.

Debentures with a floating rate of interest

These are debentures for which the coupon rate of interest can be changed by the issuer, in
accordance with changes in market rates of interest. They may be attractive to both lenders and
borrowers when interest rates are volatile.

Security

Loan stock and debentures will often be secured. Security may take the form of either a fixed
charge or a floating charge.
a) Fixed charge; Security would be related to a specific asset or group of assets, typically land
and buildings. The company would be unable to dispose of the asset without providing a
substitute asset for security, or without the lender's consent.

b) Floating charge; With a floating charge on certain assets of the company (for example,
stocks and debtors), the lender's security in the event of a default payment is whatever assets
of the appropriate class the company then owns (provided that another lender does not have a
prior charge on the assets). The company would be able, however, to dispose of its assets as it
chose until a default took place. In the event of a default, the lender would probably appoint a
receiver to run the company rather than lay claim to a particular asset.

The redemption of loan stock

Loan stock and debentures are usually redeemable. They are issued for a term of ten years or
more, and perhaps 25 to 30 years. At the end of this period, they will "mature" and become
redeemable (at par or possibly at a value above par).

Most redeemable stocks have an earliest and latest redemption date. For example, 18%
Debenture Stock 2007/09 is redeemable, at any time between the earliest specified date (in
2007) and the latest date (in 2009). The issuing company can choose the date. The decision by
a company when to redeem a debt will depend on:

a) how much cash is available to the company to repay the debt

b) the nominal rate of interest on the debt. If the debentures pay 18% nominal interest and the
current rate of interest is lower, say 10%, the company may try to raise a new loan at 10% to
redeem the debt which costs 18%. On the other hand, if current interest rates are 20%, the
company is unlikely to redeem the debt until the latest date possible, because the debentures
would be a cheap source of funds.

There is no guarantee that a company will be able to raise a new loan to pay off a maturing
debt, and one item to look for in a company's balance sheet is the redemption date of current
loans, to establish how much new finance is likely to be needed by the company, and when.

Mortgages are a specific type of secured loan. Companies place the title deeds of freehold or
long leasehold property as security with an insurance company or mortgage broker and receive
cash on loan, usually repayable over a specified period. Most organisations owning property
which is unencumbered by any charge should be able to obtain a mortgage up to two thirds of
the value of the property.

As far as companies are concerned, debt capital is a potentially attractive source of finance
because interest charges reduce the profits chargeable to corporation tax.

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. The major reasons for using retained earnings to finance new investments,
rather than to pay higher dividends and then raise new equity for the new investments, are as
follows:
a) The management of many companies believes that retained earnings are funds which do not
cost anything, although this is not true. However, it is true that the use of retained earnings as a
source of funds does not lead to a payment of cash.

b) The dividend policy of the company is in practice determined by the directors. From their
standpoint, retained earnings are an attractive source of finance because investment projects
can be undertaken without involving either the shareholders or any outsiders.

c) The use of retained earnings as opposed to new shares or debentures avoids issue costs.

d) The use of retained earnings avoids the possibility of a change in control resulting from an
issue of new shares.

Another factor that may be of importance is the financial and taxation position of the company's
shareholders. If, for example, because of taxation considerations, they would rather make a
capital profit (which will only be taxed when shares are sold) than receive current income, then
finance through retained earnings would be preferred to other methods.

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.

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:

a) an overdraft, which a company should keep within a limit set by the bank. Interest is charged
(at a variable rate) on the amount by which the company is overdrawn from day to day;

b) a short-term loan, for up to three years.

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. A loan may have a
fixed rate of interest or a variable interest rate, so that the rate of interest charged will be
adjusted every three, six, nine or twelve months in line with recent movements in the Base
Lending Rate.

Lending to smaller companies will be at a margin above the bank's base rate and at either a
variable or fixed rate of interest. Lending on overdraft is always at a variable rate. A loan at a
variable rate of interest is sometimes referred to as a floating rate loan. Longer-term bank loans
will sometimes be available, usually for the purchase of property, where the loan takes the form
of a mortgage. When a banker is asked by a business customer for a loan or overdraft facility,
he will consider several factors, known commonly by the mnemonic PARTS.
- Purpose
- Amount
- Repayment
- Term
- Security
P The purpose of the loan A loan request will be refused if the purpose of the loan is not acceptable to
the bank.
A The amount of the loan. The customer must state exactly how much he wants to borrow. The banker
must verify, as far as he is able to do so, that the amount required to make the proposed investment
has been estimated correctly.
R How will the loan be repaid? Will the customer be able to obtain sufficient income to make the
necessary repayments?
T What would be the duration of the loan? Traditionally, banks have offered short-term loans and
overdrafts, although medium-term loans are now quite common.
S Does the loan require security? If so, is the proposed security adequate?

Leasing
A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a
capital asset, but allows the lessee to use it. The lessee makes payments under the terms of the
lease to the lessor, for a specified period of time.

Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery,
cars and commercial vehicles, but might also be computers and office equipment. There are two
basic forms of lease: "operating leases" and "finance leases".

Operating leases

Operating leases are rental agreements between the lessor and the lessee whereby:

a) the lessor supplies the equipment to the lessee

b) the lessor is responsible for servicing and maintaining the leased equipment

c) the period of the lease is fairly short, less than the economic life of the asset, so that at the
end of the lease agreement, the lessor can either

i) lease the equipment to someone else, and obtain a good rent for it, or
ii) sell the equipment secondhand.

Finance leases

Finance leases are lease agreements between the user of the leased asset (the lessee) and a
provider of finance (the lessor) for most, or all, of the asset's expected useful life.

Suppose that a company decides to obtain a company car and finance the acquisition by means
of a finance lease. A car dealer will supply the car. A finance house will agree to act as lessor in
a finance leasing arrangement, and so will purchase the car from the dealer and lease it to the
company. The company will take possession of the car from the car dealer, and make regular
payments (monthly, quarterly, six monthly or annually) to the finance house under the terms of
the lease.

Other important characteristics of a finance lease:

a) The lessee is responsible for the upkeep, servicing and maintenance of the asset. The lessor
is not involved in this at all.

b) The lease has a primary period, which covers all or most of the economic life of the asset. At
the end of the lease, the lessor would not be able to lease the asset to someone else, as the
asset would be worn out. The lessor must, therefore, ensure that the lease payments during the
primary period pay for the full cost of the asset as well as providing the lessor with a suitable
return on his investment.

c) It is usual at the end of the primary lease period to allow the lessee to continue to lease the
asset for an indefinite secondary period, in return for a very low nominal rent. Alternatively, the
lessee might be allowed to sell the asset on the lessor's behalf (since the lessor is the owner)
and to keep most of the sale proceeds, paying only a small percentage (perhaps 10%) to the
lessor.

Why might leasing be popular

The attractions of leases to the supplier of the equipment, the lessee and the lessor are as
follows:

 The supplier of the equipment is paid in full at the beginning. The equipment is sold to the
lessor, and apart from obligations under guarantees or warranties, the supplier has no further
financial concern about the asset.

 The lessor invests finance by purchasing assets from suppliers and makes a return out of the
lease payments from the lessee. Provided that a lessor can find lessees willing to pay the
amounts he wants to make his return, the lessor can make good profits. He will also get capital
allowances on his purchase of the equipment.

 Leasing might be attractive to the lessee:

i) if the lessee does not have enough cash to pay for the asset, and would have difficulty
obtaining a bank loan to buy it, and so has to rent it in one way or another if he is to have the
use of it at all; or

ii) if finance leasing is cheaper than a bank loan. The cost of payments under a loan might
exceed the cost of a lease.

Operating leases have further advantages:

 The leased equipment does not need to be shown in the lessee's published balance sheet,
and so the lessee's balance sheet shows no increase in its gearing ratio.
 The equipment is leased for a shorter period than its expected useful life. In the case of high-
technology equipment, if the equipment becomes out-of-date before the end of its expected life,
the lessee does not have to keep on using it, and it is the lessor who must bear the risk of
having to sell obsolete equipment secondhand.

The lessee will be able to deduct the lease payments in computing his taxable profits.

Hire purchase
Hire purchase is a form of instalment credit. Hire purchase is similar to leasing, with the
exception that ownership of the goods passes to the hire purchase customer on payment of the
final credit instalment, whereas a lessee never becomes the owner of the goods.

Hire purchase agreements usually involve a finance house.

i) The supplier sells the goods to the finance house.

ii) The supplier delivers the goods to the customer who will eventually purchase them.
iii) The hire purchase arrangement exists between the finance house and the customer.

The finance house will always insist that the hirer should pay a deposit towards the purchase
price. The size of the deposit will depend on the finance company's policy and its assessment of
the hirer. This is in contrast to a finance lease, where the lessee might not be required to make
any large initial payment.

An industrial or commercial business can use hire purchase as a source of finance. With
industrial hire purchase, a business customer obtains hire purchase finance from a finance
house in order to purchase the fixed asset. Goods bought by businesses on hire purchase
include company vehicles, plant and machinery, office equipment and farming machinery.

Government assistance
The government provides finance to companies in cash grants and other forms of direct
assistance, as part of its policy of helping to develop the national economy, especially in high
technology industries and in areas of high unemployment. For example, the Indigenous
Business Development Corporation of Zimbabwe (IBDC) was set up by the government to
assist small indigenous businesses in that country.

Venture capital
Venture capital is money put into an enterprise which may all be lost if the enterprise fails. A
businessman starting up a new business will invest venture capital of his own, but he will
probably need extra funding from a source other than his own pocket. However, the term
'venture capital' is more specifically associated with putting money, usually in return for an
equity stake, into a new business, a management buy-out or a major expansion scheme.

The institution that puts in the money recognises the gamble inherent in the funding. There is a
serious risk of losing the entire investment, and it might take a long time before any profits and
returns materialise. But there is also the prospect of very high profits and a substantial return on
the investment. A venture capitalist will require a high expected rate of return on investments, to
compensate for the high risk.

A venture capital organisation will not want to retain its investment in a business indefinitely, and
when it considers putting money into a business venture, it will also consider its "exit", that is,
how it will be able to pull out of the business eventually (after five to seven years, say) and
realise its profits. Examples of venture capital organisations are: Merchant Bank of Central
Africa Ltd and Anglo American Corporation Services Ltd.

When a company's directors look for help from a venture capital institution, they must recognise
that:

 the institution will want an equity stake in the company

 it will need convincing that the company can be successful
 it may want to have a representative appointed to the company's board, to look after its
interests.

The directors of the company must then contact venture capital organisations, to try and find
one or more which would be willing to offer finance. A venture capital organisation will only give
funds to a company that it believes can succeed, and before it will make any definite offer, it will
want from the company management:

a) a business plan

b) details of how much finance is needed and how it will be used

c) the most recent trading figures of the company, a balance sheet, a cash flow forecast and a
profit forecast

d) details of the management team, with evidence of a wide range of management skills

e) details of major shareholders

f) details of the company's current banking arrangements and any other sources of finance

g) any sales literature or publicity material that the company has issued.

A high percentage of requests for venture capital are rejected on an initial screening, and only a
small percentage of all requests survive both this screening and further investigation and result
in actual investments.

Franchising
Franchising is a method of expanding business on less capital than would otherwise be needed.
For suitable businesses, it is an alternative to raising extra capital for growth. Franchisors
include Budget Rent-a-Car, Wimpy, Nando's Chicken and Chicken Inn.

Under a franchising arrangement, a franchisee pays a franchisor for the right to operate a local
business, under the franchisor's trade name. The franchisor must bear certain costs (possibly
for architect's work, establishment costs, legal costs, marketing costs and the cost of other
support services) and will charge the franchisee an initial franchise fee to cover set-up costs,
relying on the subsequent regular payments by the franchisee for an operating profit. These
regular payments will usually be a percentage of the franchisee's turnover.

Although the franchisor will probably pay a large part of the initial investment cost of a
franchisee's outlet, the franchisee will be expected to contribute a share of the investment
himself. The franchisor may well help the franchisee to obtain loan capital to provide his-share
of the investment cost.

The advantages of franchises to the franchisor are as follows:

 The capital outlay needed to expand the business is reduced substantially.

 The image of the business is improved because the franchisees will be motivated to achieve
good results and will have the authority to take whatever action they think fit to improve the
results.

The advantage of a franchise to a franchisee is that he obtains ownership of a business for an

agreed number of years (including stock and premises, although premises might be leased from
the franchisor) together with the backing of a large organisation's marketing effort and
experience. The franchisee is able to avoid some of the mistakes of many small businesses,
because the franchisor has already learned from its own past mistakes and developed a
scheme that works.

Now attempt exercise 7.1.

Exercise 7.1 Sources of finance

Outdoor Living Ltd., an owner-managed company, has developed a new type of heating using
solar power, and has financed the development stages from its own resources. Market research
indicates the possibility of a large volume of demand and a significant amount of additional
capital will be needed to finance production.

Advise Outdoor Living Ltd. on:

a) the advantages and disadvantages of loan or equity capital

b) the various types of capital likely to be available and the sources from which they might be
obtained

c) the method(s) of finance likely to be most satisfactory to both Outdoor Living Ltd. and the
provider of funds