CHAPTER SEVEN: PROJECT FINANCING

7.1. Source of Project Finance

There are majorly two types of project financing: equity and debt financing. But leasing can be
the other source of project financing. When looking for money, you must consider your
company’s debt-to-equity ratio. The relation between amounts borrowed and amounts invested to
the business by the owners. The more money owners have invested in their business, the easier it
is to attract financing.

The proportion of debt to equity depends on how well the financial market is organized and the
availability of debt financing. In addition, the existence of capital markets and the legal
environment governing it will have a critical impact. However, shortage of financial resources
will be a critical constraint of implementing feasible investment projects.

A. Equity Financing:

Most small or growth-stage businesses use limited equity financing. As with debt financing,
additional equity often comes from non-professional investors such as friends, relatives,
employees, customers, or industry colleagues.

However, the most common source of professional equity funding comes from venture
capitalists. These are institutional risk takers and may be groups of wealthy individuals,
government-assisted sources, or major financial institutions. Most specialize in one or a few
closely related industries. Venture capitalists may scrutinize thousands of potential investments
annually, but only invest in a handful. The possibility of a public stock offering is critical to
venture capitalists. Quality management, a competitive or innovative advantage, and industry
growth are also major concerns.

B. Debt Financing:

There are many sources for debt financing: banks, savings and loans, commercial finance
companies, and the microfinance institutions. State and local governments have developed many
programs in recent years to encourage the growth of small businesses in recognition of their
positive effects on the economy.

Family members, friends, and former associates are all potential sources, especially when capital
requirements are smaller. Traditionally, banks have been the major source of small business
funding. Their principal role has been as a short-term lender offering demand loans, seasonal
lines of credit, and single-purpose loans for machinery and equipment.

In addition to equity considerations, lenders commonly require the borrower’s personal

guarantees in case of default. This ensures that the borrower has a sufficient personal interest at

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stake to give paramount attention to the business. For most borrowers this is a burden, but also a
necessity.

C. Lease Financing

CONCEPT OF LEASE FINANCING

Lease financing denotes procurement of assets through lease. The subject of leasing falls in the
category of finance. Leasing has grown as a big industry in the USA and UK and spread to other
countries during the present century. In India, the concept was pioneered in 1973 when the First
Leasing Company was set up in Madras and the eighties have seen a rapid growth of this
business. Lease as a concept involves a contract whereby the ownership, financing and risk
taking of any equipment or asset are separated and shared by two or more parties. Thus, the
lessor may finance and lessee may accept the risk through the use of it while a third party may
own it. Alternatively the lessor may finance and own it while the lessee enjoys the use of it and
bears the risk. There are various combinations in which the above characteristics are shared by
the lessor and lessee.

MEANING 0F LEASE FINANCING

A lease transaction is a commercial arrangement whereby an equipment owner or Manufacturer
conveys to the equipment user the right to use the equipment in return for a rental. In other
words, lease is a contract between the owner of an asset (the lessor) and its user (the lessee) for
the right to use the asset during a specified period in return for a mutually agreed periodic
payment (the lease rentals). The important feature of a lease contract is separation of the
ownership of the asset from its usage. Lease financing is based on the observation made by
Donald B. Grant: “Why own a cow when the milk is so cheap? All you really need is milk and
not the cow.”

IMPORTANCE 0F LEASE FINANCING

Leasing industry plays an important role in the economic development of a country by providing
money incentives to lessee. The lessee does not have to pay the cost of asset at the time of
signing the contract of leases. Leasing contracts are more flexible so lessees can structure the
leasing contracts according to their needs for finance. The lessee can also pass on the risk of
obsolescence to the lessor by acquiring those appliances, which have high technological
obsolescence. Today, most of us are familiar with leases of houses, apartments, offices, etc.

TYPES OF LEASE AGREEMENTS

Lease agreements are basically of two types. They are (a) Financial lease and (b) Operating
lease. The other variations in lease agreements are (c) Sale and lease back (d) Leveraged leasing
and (e) Direct leasing.

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 LEASE
AGREEMENTS

CAPITAL SALE
LEASE/FINANCIA OPERATING
AND LEVERAGED
L LEASE LEASE
LEASE LEASING DIRECT
BACK LEASING

Figure 15.1: Types of leases

FINANCIAL LEASE
Long-term, non-cancellable lease contracts are known as financial leases. The essential point of
financial lease agreement is that it contains a condition whereby the lessor agrees to transfer the
title for the asset at the end of the lease period at a nominal cost. At lease it must give an option
to the lessee to purchase the asset he has used at the expiry of the lease. Under this lease the
lessor recovers 90% of the fair value of the asset as lease rentals and the lease period is 75% of
the economic life of the asset. The lease agreement is irrevocable. Practically all the risks
incidental to the asset ownership and all the benefits arising there from are transferred to the
lessee who bears the cost of maintenance, insurance and repairs. Only title deeds remain with the
lessor. Financial lease is also known as ‘capital lease’. In India, financial leases are very popular
with high-cost and high technology equipment.

OPERATING LEASE
An operating lease stands in contrast to the financial lease in almost all aspects. This lease
agreement gives to the lessee only a limited right to use the asset. The lessor is responsible for
the upkeep and maintenance of the asset. The lessee is not given any uplift to purchase the asset
at the end of the lease period. Normally the lease is for a short period and even otherwise is
revocable at a short notice. Mines, Computers hardware, trucks and automobiles are found
suitable for operating lease because the rate of obsolescence is very high in this kind of assets.

SALE AND LEASE BACK

It is a sub-part of finance lease. Under this, the owner of an asset sells the asset to a party (the
buyer), who in turn leases back the same asset to the owner in consideration of lease rentals.
However, under this arrangement, the assets are not physically exchanged but it all happens in
records only. This is nothing but a paper transaction. Sale and lease back transaction is suitable
for those assets, which are not subjected depreciation but appreciation, say land. The advantage
of this method is that the lessee can satisfy himself completely regarding the quality of the asset
and after possession of the asset convert the sale into a lease arrangement. The sale and lease
back transaction can be expressed with the help of the following figure.

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 SELLER SALE TRANSACTION BUYER
SALE VALUE

LEASE TRANSACTION

LESSEE LESSOR
LEASE RENTALS

Under this transaction, the seller assumes the role of a lessee and the buyer assumes the role of a
lessor. The seller gets the agreed selling price and the buyer gets the lease rentals. It is possible to
structure the sale at agreed value (below or above the fair market price) and to adjust difference
in the lease rentals. Thus the effect of profit /loss on sale of assets can be deferred.

LEVERAGED LEASING
Under leveraged leasing arrangement, a third party is involved beside lessor and lessee. The
lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender
and the asset so purchased is held as security against the loan. The lender is paid off from the
lease rentals directly by the lessee and the surplus after meeting the claims of the lender goes to
the lessor. The lessor, the owner of the asset is entitled to depreciation allowance associated with
the asset.

Manufacturer Lessor Lessee

Sells Asset Leases Asset

Lender

Figure 15. 3: Leveraged Lease

DIRECT LEASING
Under direct leasing, a firm acquires the right to use an asset from the manufacturer directly. The
ownership of the asset leased out remains with the manufacturer itself. The major types of direct

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lessor include manufacturers, finance companies, independent lease companies, special purpose
leasing companies etc

ADVANTAGES OF LEASING
There are several extolled advantages of acquiring capital assets on lease:
1. SAVING OF CAPITAL: Leasing covers the full cost of the equipment used in the
business by providing 100% finance. The lessee is not to provide or pay any margin
money as there is no down payment. In this way the saving in capital or financial
resources can be used for other productive purposes e.g. purchase of inventories.
2. FLEXIBILITY AND CONVENIENCE: The lease agreement can be tailor- made in
respect of lease period and lease rentals according to the convenience and requirements
of all lessees.
3. PLANNING CASH FLOWS: Leasing enables the lessee to plan its cash flows properly.
The rentals can be paid out of the cash coming into the business from the use of the same
assets.
4. IMPROVEMENT IN LIQUADITY: Leasing enables the lessee to improve their
liquidity position by adopting the sale and lease back technique.

7.2. Cost of Capital

he cost of capital for any particular capital source or security issue is called the specific cost of
capital. It is also called individual cost of capital or component cost of capital.
Each type of capital contained the capital structure of a firm include:
1. Debt
2. Preferred stock
3. Common stock
4. Retained earnings

Two important points you should bear in mind about the specific cost of capital. One is that it is
computed on an after-tax basis. Meaning, if there would be any tax implication on the individual
source of capital, it should be considered. In almost all circumstances, the tax implication is only
on debt sources of finance. The second point is that the specific cost of capital is expressed as an
annual percentage or rate like 6%, 9%, or 10%. The cost of capital is not stated in terms of birrs.

1. The cost of debt

This is the minimum rate of return required by suppliers of debt. The relevant specific cost of
debt is the after-tax cost of new debt. Generally, debt is the cheapest source of finance to a firm
and, hence, the cost of debt is the lowest specific cost of capital. There are two basic
explanations for this. First, debt suppliers, generally, assume the lowest risk among all suppliers
of capital. They receive interest payments before preferred and common dividends are paid.
Since they assume the smallest risk, their return is the lowest. Their lowest return would be the
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lowest cost of capital to the firm. Second, raising capital through debt sources entails interest
expense. The inters expense in turn reduces the firm’s income which ultimately would cause tax
payment to be reduced. So raising money in the form of debt results in the smallest tax burden,
and finally, the firm’s cost of debt would be the lowest.

Debt sources of finance may take several forms like bonds, promissory notes, bank loans. Here,
for our convenience we consider bond issue to illustrate the cost of debt.

Computing the cost of new bond issue involves three steps:

i) Determine the net proceeds from the sale of each bond
NPd = Pd – f
Where:
NPd = The net proceeds from the sale of each bond
Pd = The market price of the bond
f = Flotation costs
ii) Compute the effective before tax cost of the bond using the following approximation formula:
Pn − NPd
I+
n
Pn+NPd
Kd = 2
Where:
Kd = The effective before tax cost of debt
I = Annual interest payment
Pn = The par value of the bond
n = Length of the holding period of the bond in years.

iii) Compute the after-tax cost of debt

Kdt = Kd (1 – t)
Where:
Kdt = The after-tax cost of debt
t = The marginal tax rate

Example: Currently, Abyssinia Industrial Group is planning to sell 15-year, Br. 1,000 par-value
bonds that carry a 12% annual coupon interest rate. As a result of lower current interest rates,
Abyssinia bonds can be sold for Br. 1,010 each. Flotation costs of Br. 30 per bond will be
incurred in the process of issuing the bonds. The firm’s marginal tax rate is 40%.

Required: Calculate the after tax cost of Abyssinia’s new bond issue:
Solution:
Given: Pn = Br. 1,000; I = Br. 120 (Br. 1,000 x 12%); n = 15; Pd = Br. 1,010; f = Br. 30;

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 t = 40%; Kdt = ?
Then apply the three steps:
i) NPd = Br. 1,010 – Br. 30 = Br. 980
Br .1 , 000−Br . 980
Br .120 +
15
= 12. 26 %
Br .1 , 000+Br . 980
ii) Kd = 2
iii) Kdt = 12.26% (1 – 40%) = 7.36%

Therefore, the after – tax cost of Abyssinia’s new bond issue is 7.36%. That is, Abyssinia should
be able to earn a minimum of 7.36% to satisfy bondholders. Otherwise, the firm’s value will
decline.

2. The cost of preferred stock

The cost of preferred stock is the minimum rate of return a firm must earn in order to satisfy the
required rate of return of the firm’s preferred stock investors. It is also the minimum rate of
return a firm’s preferred stock investors require if they are to purchase the firm’s preferred stock.

When a firm raises capital by issuing new preferred stock, it is expected to pay fixed amount of
dividends to the preferred stockholders. So it is the dividend payment that is the cost of the
preferred stock to the firm stated as an annual rate.

The cost of a new preferred stock issue can be computed by following two steps:

i) Determine the net proceeds from the sale of each preferred stock.
NPpf = Ppf – f
Where:
NPpf = Net proceeds from the sale of each preferred stock
Ppf = Market price of the preferred stock
f = Flotation costs
ii) Compute the cost of preferred stock issue
Kps = Dps__
NPpf
Where:
Kps = The cost of preferred stock
DPs = The pre share annual dividend on the preferred stock

Example: Sefa Computer Systems Company has just issued preferred stock. The stock has 12%
annual dividend and Br. 100 par value and was sold at 102% of the par value. In addition,
flotation costs of Br. 2.50 per share must be paid. Calculate the cost of the preferred stock.

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Solution:
Given: Pps = Br. 102 (Br. 100 x 102%); Dps = Br. 12 (Br 100 x 12%); f = Br. 2.50;
Kps =?
Then apply the two steps:

i) NPpf = Br. 102 – Br. 2.50 = Br. 99.50

ii) Kps = Br. 12 =12.06%
Br. 99.50

Therefore, Sefa Company should be able to earn a minimum of 12.06% on any investment
financed by the new preferred stock issue. Otherwise, the firm’s value will decrease.

3. The cost of common stock

The cost of common stock is the minimum rate of return that a firm must earn for its common
stockholders in order to maintain the value of the firm. A firm does not make explicit
commitment to pay dividends to common stockholders. However, when common stockholders
invest their money in a corporation, they expect returns in the form of dividends. Therefore,
common stocks implicitly involve a return in terms of the dividends expected by investors and
hence, they carry cost.

Generally, common stock dividends are paid after interest and preferred dividends are paid. As a
result, common stock investors assume the maximum risk in corporate investment. They
compensate the maximum risk by requiring the highest return. This highest return expected by
common stockholders make common stock the most expensive source of capital.

The cost of common stock can be computed using the constant growth valuation model.
Ks = D1 + g
NPo
Where:
Ks = The cost of new common stock issue
D1 = The expected dividend payment at the end of next year
NPo = Net proceeds from the sale of each common stock
g = The expected annual dividends growth rate

The net proceeds from the sale of each common stock (NPo) is computed as follows:
NPo = Po – f
Where:
Po = The current market price of the common stock
f = flotation costs

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Example: An issue of common stock is sold to investors for Br. 20 per share. The issuing
corporation incurs a selling expense of Br. 1 per share. The current dividend is Br. 1.50 per share
and it is expected to grow at 6% annual rate. Compute the specific cost of this common stock
issue.

Solution
Given: Po = Br. 20; Do = Br. 1.50; g = 6%; f = Br. 1; Ks = ?
Then apply the two steps:

i) NPo = Br. 20 – Br. 1 = Br. 19

ii) Ks = D1 + g = Br. 1.50 (1.06) = 14.37%
Npo Br. 19
Therefore, the firm should be able to earn a minimum return of 14.37% on investments that are
financed by the new common stock issue.

4. The cost of Retained Earnings

Retained earnings represent profits available for common stockholders that the corporation
chooses to reinvest in itself rather than payout as dividends. Retained earnings are not securities
like stocks and bonds and hence do not have market price that can be used to compute costs of
capital.

The cost of retained earnings is the rate of return a corporation’s common stockholders expect
the corporation to earn on their reinvested earnings, at least equal to the rate earned on the
outstanding common stock. Therefore, the specific cost of capital of retained earnings is equated
with the specific cost of common stock. However, flotation costs are not involved in the case of
retained earnings.

Computing the cost of retained earnings involves just a single procedure of applying the
following formula:

Kr = D1 + g
Po
Where:
Kr = The cost of retained earnings
D1 = The expected dividends payment at the end of next year
Po = The current market price of the firm’s common stock
g = The expected annual dividend growth rate.
Example: Zeila Auto Spare Parts Manufacturing company expects to pay a common stock
dividend of Br. 2.50 per share during the next 12 months. The firm’s current common stock price
is Br. 50 per share and the expected dividend growth rate is 7%. A flotation cost of Br. 3 is
involved to sale a share of common stock.
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Required: Compute the cost of retained earnings

Solution
Given: Po = Br. 50; D1 = Br. 2.50; g = 7%; Kr = ?
Then apply the formula:
Kr = D1+ g = Br. 2.50 + 7% = 12%
Po Br. 50

7.3. Financing Institutions

Financial institutions are business organizations that act as mobilizes and depositories of savings, and
as purveyors of credit or finance. They also provide various financial services to the community. They
differ from non-financial business organizations in respect of their wares, i.e., while the former deal in
financial assets such as deposits, loans, securities, and so on, the latter deal in real assets such as
machinery, equipment, stocks of goods, real estate, and so on. The activities of different financial
institutions may be either specialized or they may overlap; quite often they overlap. Yet, we need to
classify the financial institutions and this is done on such basis as their primary activity or the degree
of their specialization with relation to savers or borrowers with whom they customarily deal or the
manner of their creation.
Financial institutions provide various types of financial services in an economy. Financial
intermediaries are a special group of financial institutions that obtain funds by issuing claims to market
participants and use these funds to purchase financial assets. In the next section we will discuss the
different services of financial institutions. We will also discuss the role of financial intermediaries,
which is the most important type of financial institutions.

Types of Financial Institution

Generally speaking there are two types of financial institutions. These are Depository Financial
Institutions and Non-Depository Financial Institutions

Depository Financial Institutions

Depository institutions include commercial banks (or simply banks), savings and loan associations,
saving banks, and credit unions. All are financial intermediaries that acquire the bulk of their funds by
offering their liabilities to the public mostly in the form of deposits. Once they raise funds through
deposits and other funding sources, depository institutions both make direct loans to various entities
and invest in securities. In this section we will discuss the activities of each depository institutions,
funding sources, asset /liability problem of all depository institutions and other aspects of it.
All depository institutions accept deposit. The major differences among these types of institutions lie
in that how they are owned and in the sources and uses of funds. The income of depository institutions
is derived from two sources: (1) the income generated from the loans they make and the securities they
purchase and (2) fee income. Depository institutions are highly regulated because of the vital role that
they play in the country’s financial system. Demand deposit accounts are the principal means that
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individuals and business entities use for making payments, and government monetary policy is
implemented through the banking system.

Depository institutions hold liquid assets not only for operational purposes, but also because of the
regulatory requirements. In what immediately follows we will discuss the different aspects of each
depository institution (commercial banks and specialized types of depository institutions – savings and
loan associations, savings banks, and credit unions- commonly referred to as thrifts.)

Non-Depository Financial Institutions

Non-depository financial institutions (insurance companies, pension funds, mutual funds, finance
companies and investment banks) do not accept deposits. They raise funds by offering legal
contracts, selling shares to the public, borrowing in the money market and issuing long-term
debt.
a) Insurance Companies
b) Pension Funds
c) Mutual Funds
d) Finance Companies
e) Investment Banks

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