Financing Decision

8 April 2023 1

The Financing DecisionThe Financing Decision

8 April 2023 2

Financing Decisions (Cont…)Financing Decisions (Cont…)• The most important sources available to

corporations are:– Equity financing– Preference shares– Loan stocks (debentures)– Convertible loan stocks– Term loans– Leases– Grants

The Cost of Capital The Cost of Capital and Capital and Capital StructureStructure

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The Cost of CapitalThe Cost of Capital• The rate of return required by investors

supplying funds to a company.– It is, thus, the minimum rate of return

required on prospective projects

8 April 2023

Cost of Capital...Cost of Capital...• Is an application that uses what we learned in

Risk/Return• May be used as a discount rate or a hurdle

rate for evaluating some potential projects in Capital Budgeting

• Can be used as the discount rate in finding the value of the firm

• Can be used in a firm’s Shareholder Value-Based Management system (MVA)

• May be affected by a firm’s financial policies

8 April 2023

Weighted Average Cost of CapitalWeighted Average Cost of Capital

• where:– wi is the target proportion of capital from funding

source i.•This can be the existing market value proportions

if the firm is currently optimally levered.– Ri is the incremental cost to the firm of using funding

source i.• So, this formula is comprised of weights and rates.• Capital funding sources include debt, common stock,

and preferred stock.

Weights

Rates

N

iiiRwR

1

8 April 2023 7

Calculating the Cost of Calculating the Cost of Individual Sources of FinanceIndividual Sources of Finance• The first step in calculating a

company’s weighted cost of capital (WACC) is to calculate the cost of the individual components of its capital:– Equity capital– Preference shares– Debt

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Cost of Equity CapitalCost of Equity Capital• The cost of equity is the rate of return

required by the suppliers of equity finance.

• Equity finance can be raised either through issuing new securities or through the utilization of retained earnings

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The Cost of Equity (Cont..)The Cost of Equity (Cont..)• To find the cost of equity (Ke) we can

adapt the Gordon growth model:

• Where:Ke = Cost of equityP0 = ex-dividend share priceg = expected annual increase in dividendsD0 = dividend to be paid shortly

g

PgDKe

0

0 1

8 April 2023 10

The Cost of Equity (Cont..)The Cost of Equity (Cont..)• An alternative and arguably more reliable

method of calculating the cost of equity finance is to use the CAPM.

• This model allows investors to work out their required return on the equity finance of a company, based on the rate of return earned on risk-free investments plus a risk premium.– Remember that the risk premium reflects both the

systematic risk of the company and the excess generated by the market relative to the risk-free rate

8 April 2023 11

The Cost of Equity - CAPM The Cost of Equity - CAPM • Using the CAPM the cost of equity

finance is given by the following linear relationshipRj = Rf + ßj (Rm - Rf)Where:

Rj = the rate of return of security j predicted by the model

Rf = the risk-free rate of returnßj = the “beta” coefficient of security jRm = the return of the market

8 April 2023 12

The Cost of Preference SharesThe Cost of Preference Shares• Calculating the cost of a company’s

preference shares is considerably easier than calculating the cost of ordinary equity because:– Dividends paid on preference shares are usually

stable;– Preference shares are, generally speaking,

irredeemable;– Since preference dividends are a distribution of

after-tax profits, they are not tax deductible.

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The Cost of Preference Shares (Cont..)The cost of irredeemable preference shares (Kps) can be calculated from the ex-dividend market price and the dividend payable using the following model

dividendexvalueMarketpayableDividendK ps

If calculating the cost of raising new preference shares, the above equation can be modified, as can the Gordon model, to take into account issue costs

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The Cost of Preference Shares The Cost of Preference Shares (Cont..)(Cont..)

The cost of irredeemable preference shares (Kps)can be calculated from the ex-dividend market priceand the dividend payable using the following model

dividendexvalueMarketpayableDividendK ps

If calculating the cost of raising new preferenceshares, the above equation can be modified, as can the Gordon model, to take into account issue costs

8 April 2023 15

The Cost of DebtThe Cost of Debt• The cost of debt is the rate of return

required by the suppliers of debt finance.• There are two major types of securitized

debt:– Irredeemable bonds; and– Redeemable bonds

• The cost of irredeemable bonds is calculated in a similar manner to that of irredeemable preference shares.– In both cases, the model being used is one that

values a perpetual stream of cash flows.

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The Cost of Irredeemable BondsSince the interest payments made on irredeemable bonds are tax deductible, it will have both a before- and after-tax cost of debt.

The before-tax cost of irredeemable debt (Kid) can be calculated as:

bondofvalueMarketpayablerateInterest

Kid

The after-tax cost of debt is then easily obtained if the company taxation rate (T) is assumed to be constant:

Kid (after tax) = Kid (1 - T)

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The Cost of Redeemable The Cost of Redeemable BondsBonds

• To find the cost of redeemable bonds we need to find the overall required return of the providers of debt finance, which combines both revenue (interest) and capital (principal) returns.

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The Cost of Redeemable Bonds (Cont..)The overall required return of the providers of debt finance is equivalent to the internal rate of return (Kd) of the following valuation model

ndddd KRVI

KI

KI

KI

P

1

..................111 320

Where:I = annual interest paymentRV = redemption valueKd = cost of debt before taxP0 = current market price of bondn = number of years to redemption

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The Cost of Redeemable Bonds The Cost of Redeemable Bonds (Cont..)(Cont..)

• In order to estimate Kd using the valuation model, trial and error or linear interpolation methods can be used (as is the case for IRR).

• Alternatively, to save the trouble of doing an interpolation calculation, Kd can be estimated using the yield approximation method developed by Hawanini and Vora (1982)

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Cost of Redeemable Debt - Cost of Redeemable Debt - Yield Approximation MethodYield Approximation Method

• The yield approximation method is given by the following equation

• Where:P = par value or face valueNPD = net proceeds from sale or market valueI = annual interest paymentn = number of years to redemption

PNPDPnNPDP

IKd

6.0

8 April 2023 21

Cost of Redeemable Debt - Yield Cost of Redeemable Debt - Yield Approximation Method (Cont..)Approximation Method (Cont..)

• The yield approximation methods give the before tax cost of debt. The after tax cost of debt can, again, be easily obtained using the company taxation rate (T)Kd (after tax) = Kd (1 - T)

• More accurately, the determination of the after-tax cost of debt should take account of the way in which interest payments and principal are treated from a taxation perspective.– This may vary between different taxation systems.

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Bank BorrowingsBank Borrowings• The source of finance considered so far have all

been in security form and have a market price with which to relate interest and dividend payments to in order to calculate their cost.

• This is not true of bank borrowing or any other debt that has no market price.

• To approximate the cost of such debts the interest rate paid on the loan should be taken, making the appropriate calculation to allow for the tax deductibility of the interest payments.

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Calculating the WACCCalculating the WACC• Once the costs of a company’s individual sources

of finance have been calculated, the overall WACC can be determined.

• In order to calculate the WACC, the costs of the individual sources of finance are weighted according to their relative importance as a source of finance.

• WACC can be calculated either for the existing capital structure (average basis) or for additional incremental finance packages (marginal basis).

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Calculating the WACC (Cont..)Calculating the WACC (Cont..)• WACC was presented as:

• Thus, the WACC equation for a company financed solely by debt and equity finance is represented by:

Where:E = Value of equityD = Value of debt

N

iiiRwR

1

ED

DxTKEDExK

WACC de

1

8 April 2023 25

Calculating the WACC (Cont..)Calculating the WACC (Cont..)• Note that the WACC equation will expand according to

the number of different sources that a company draws its capital from.

• For instance, for a company using equity finance, preference shares and both redeemable and irredeemable debt, the equation will become:

Where: P, Di and Dr are the value of preference shares, irredeemable debt and redeemable debt respectively.

ri

rrd

ri

iid

ri

ps

ri

e

DDPEDTK

DDPEDTK

DDPEPxK

DDPEExK

WACC

11

8 April 2023 26

Market or Book Value Weightings?Market or Book Value Weightings?• The next question that needs to be

answered is how the different costs of finance are weighted.

• Here we are faced with two choices:– Book values or market values.

• Book values are easily obtained from a company’s accounts while market values are obtainable from the financial press and from various financial databases

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Market or Book Value Weightings? Market or Book Value Weightings? (Cont..)(Cont..)

• While book values are easy to access, their use to determine WACC cannot be recommended.– Book values are based on historic costs and

rarely reflect the current required return of providers of finance, whether equity or debt.

– The nominal value of equity, for example, is usually only a fraction of its market value.

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The Concept of an Optimal The Concept of an Optimal Capital StructureCapital Structure

• The issue at hand is whether financing decisions can have an effect on investment decisions and thereby affect the value of the company.– Will the way in which a company finances its

assets (i.e. how much debt a company uses relative to equity) affect the company’s overall cost of capital and hence company value?

– If an optimum financing mix exists, then it would be in a company’s best interests to locate it and move towards this optimal capital structure.

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Factors Affecting the Level of Factors Affecting the Level of ReturnReturn

• The level of return required by shareholders and debt holders will reflect the risk they are facing.– We already know that the required rate of return

of shareholders will always be higher than that of debt holders, due to the former facing higher levels of risk

– What needs further clarifications are the factors that determine the shape of the cost of debt and the cost of equity curves faced by the company (i.e. the relationship between those costs of capital and the level of gearing)

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Fig 1: Determinants of a company’s cost of equity finance

Level of gearing

Financial risk

Business risk

Risk-free rate

Bankruptcy risk

Required rate of return

0

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Determinants of a company’s Determinants of a company’s cost cost

of equity finance (Cont..)of equity finance (Cont..)• Figure 1 summarizes the factors which

contribute to the determination of shareholders’ required rate of return.– As a starting point, shareholders will require at

least the risk-free rate of return (which can be approximated by the interest yield on short-dated government Treasury bills.

– In addition to this, they will require a premium for commercial or business risk, which is the risk associated with a company’s profits and earnings varying due to systematic influences on that company’s sector.

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of equity finance (Cont..)of equity finance (Cont..)• The level of business risk faced by shareholders

will vary from company to company, as will the required premium.– The combination of the risk-free rate and the business

risk premium will represent the cost of equity that a company will have if it is all equity financed.

– As a company starts to gear up by taking on debt finance, its distributable profits will be reduced by the interest payments it is required to make, although this reduction in profitability is lessened by the tax shield on debt.

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of equity finance (Cont..)of equity finance (Cont..)• Any volatility in operating profits will be accentuated by

the need to meet interest payments, since these payments represent an additional cost– Further volatility in distributable profits arises if

some or all of the interest payments are on floating rate rather than fixed rate debt, since the size of such payments will be determined by prevailing market interest rates.

– The volatility of distributable profits arising from the need to meet interest payments, which is called financial risk, will get progressively higher as a company’s gearing level increases.

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of equity finance - of equity finance - Financial RiskFinancial Risk• In income gearing terms, this risk is

measured by financial gearing, defined as the ratio of the percentage change in earnings available to shareholders to the percentage change in profit before interest and tax.

• Shareholders will require a premium for facing financial risk and this premium will increase with the level of a company’s gearing

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of equity finance (Cont..)of equity finance (Cont..)• Finally, at very high levels of gearing, the

possibility of the company going into liquidation increases due to its potential inability to meet its interest payments.

• At high gearing levels, shareholders will require compensation for facing bankruptcy risk in addition to their compensation for facing financial risk, and this results in a further steepening in the cost of equity curve.

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Project FinancingProject Financing

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What is a project?What is a project?• Collection of activities• Pre-determined objectives

– High operating margins.• Limited Life.• Significant free cash flows.• Few diversification opportunities.

– Asset specificity• Significant initial investment.

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What is Project Finance?What is Project Finance?Project Finance involves a corporate sponsor investing in and owning a single purpose, industrial asset through a legally independent entity financed with non-recourse debt.

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Structure HighlightsStructure Highlights• Independent, single purpose company formed to

build and operate the project. • Extensive contracting

– As many as 15 parties in upto 1000 contracts.– Contracts govern inputs, off take, construction and

operation.– Government contracts/concessions: one off or operate-

transfer.– Ancillary contracts include financial hedges, insurance

for Force Majeure, etc.

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Structure HighlightsStructure Highlights• Highly concentrated equity and debt ownership

– One to three equity sponsors.– Syndicate of banks and/or financial institutions provide

credit.– Governing Board comprised of mainly affiliated directors

from sponsoring firms.• Extremely high debt levels

– Mean debt of 70% and as high as nearly 100%.– Balance capital provided by sponsors in the form of

equity or quasi equity (subordinated debt).– Debt is non-recourse to the sponsors.– Debt service depends exclusively on project revenues.– Has higher spreads than corporate debt.

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Advantages of Project Finance Advantages of Project Finance • Has longer maturity period than normal

bank loans.

• Securitization is on project assets only.

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Disadvantages of Project Disadvantages of Project FinancingFinancing

• Takes longer to structure than equivalent size corporate finance.

• Higher transaction costs due to creation of an independent entity. Can be up to 60bp

• Project debt is substantially more expensive (50-400 basis points) due to its non-recourse nature.

• Extensive contracting restricts managerial decision making.

• Project finance requires greater disclosure of proprietary information and strategic deals.

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Financing Choice: Portfolio Financing Choice: Portfolio TheoryTheory

• Combined cash flow variance (of project and sponsor) with joint financing increases with:– Relative size of the project.– Project risk.– Positive Cash flow correlation between sponsor and project.

• Firm value decreases due to cost of financial distress which increases with combined variance.

• Project finance is preferred when joint financing (corporate finance) results in increased combined variance.

• Corporate finance is preferred when it results in lower combined variance due to diversification (co-insurance).

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Financing choice: Options TheoryFinancing choice: Options Theory• Downside exposure of the project (underlying asset)

can be reduced by buying a put option on the asset (written by the banks in the form of non-recourse debt).

• Put premium is paid in the form of higher interest and fees on loans.

• The underlying asset (project) and the option provides a payoff similar to that of call option.

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Financing choice: Options TheoryFinancing choice: Options Theory• The put option is valuable only if the Sponsor might

be able/willing to exercise the option.• The sponsor may not want to avail of project finance

(from an options perspective) because it cannot walk away from the project because:– It is in a pre-completion stage and the sponsor has provided

a completion guarantee.– If the project is part of a larger development.– If the project represents a proprietary asset.– If default would damage the firm’s reputation and ability to

raise future capital.

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Financing Choice: Options Financing Choice: Options TheoryTheory

• Derivatives are available for symmetric risks but not for binary risks, (things such as PRI are very expensive).

• Project finance (organizational form of risk management) is better equipped to handle such risks.

• Companies as sponsors of multiple independent projects: A portfolio of options is more valuable than an option on a portfolio.

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Financing Choice: Equity vs. Financing Choice: Equity vs. DebtDebt

• Reasons for high debt:

– Agency costs of equity (managerial discretion, expropriation, etc.) are high.

– Agency costs of debt (debt overhang, risk shifting) are low due to less investment opportunities.

– Debt provides a governance mechanism.

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Financing Choice: Type of Financing Choice: Type of DebtDebt

• Bank Loans:– Cheaper to issue.– Tighter covenants and better monitoring.– Easier to restructure during distress.– Lower duration forces managers to disgorge cash early.

• Project Bonds:– Lower interest rates (given good credit rating).– Less covenants and more flexibility for future growth.

• Agency Loans:– Reduce expropriation risk.– Validate social aspects of the project.

• Insider debt:– Reduce information asymmetry for future capital providers.

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Financing Choice: SequencingFinancing Choice: Sequencing• Starting with equity: eliminate risk shifting, debt

overhang and probability of distress (creditors’ requirement).

• Add insider debt (Quasi equity) before debt: reduces cost of information asymmetry.

• Large chunks vs. incremental debt: lower overall transaction costs. May result in negative arbitrage.

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Project Finance – ChoicesProject Finance – Choices

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1. Purchase from internal budget using 1. Purchase from internal budget using capital already owned by the organizationcapital already owned by the organization• The simplest type of funding• Involves the use of internal funds e.g. capital

already owned by the organization. • The investment has to be compared against:

– competing calls on funds, including those for example on increasing plant capacity;

– using funds on reserve to pay off company debt.Note: Some internal funding will always need to

be spent on the project, even if only for the initial appraisal to convince senior management and external bodies of the value of the proposed investment.

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2. Commercial Banks2. Commercial Banks• One of the main sources• In many cases a simple technical and financial

appraisal is required. • The level of interest that the firm will be

charged on its loan will, as a rule, depend on:– the size and type of the loan; – prime central bank rates;– the degree of risk involved in the loan; and – the financial strength of the borrower

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3. Debt Finance3. Debt Finance• Debt is usually a conventional commercial bank loan,

although in some circumstances debt may also be provided by institutional investors, most commonly insurance companies.

• Borrowers pay interest i.e. the cost of the debt, and repay the principal i.e. the loan amount.

• Lenders normally charge a pre-determined rate of interest which is set by adding an "interest margin" to the bank’s standard inter-bank lending rate.

• The interest margin is generally expressed in ‘basis points’ representing the bank’s return on investment or income.

• In some countries interest payments on debt may be tax deductible and this is one of the reasons debt is thought of as ‘cheaper’ then equity.

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4. Equity Finance4. Equity Finance• Represents the investment on the behalf of the owners of

the project, and usually comes from individuals, companies involved in a project such as project sponsors and equipment manufacturers, or sometimes from institutional investors like insurance companies or energy investment funds. These bodies are expected to take some form of capital stake in the project.

• Equity differs from debt in that it receives the profit from the project.

– If the project does well, the equity pay out could be significant. If the project under-performs or becomes bankrupt, however, equity investors are the last to be paid, after the banks and other claims on the project. Thus equity takes a higher risk and potentially receives higher returns to compensate

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5. Subordinated Debt5. Subordinated Debt• This is debt that ranks below the main (senior) debt

in terms of its priority of payment or in liquidation.• The senior debt is usually bank debt, and there may

be several layers of subordinated debt between the bank debt and equity. Subordinated debt principal and interest is paid only after the senior debt principal and interest is paid.

• In insolvency, subordinated debt holders receive payment only after the senior debt is paid in full. Interest paid on subordinated debt is normally tax deductible. Subordinated debt can be provided by companies involved in the particular project, or can be from third parties.

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Mezzanine financeMezzanine finance• Is a general term used to describe

various financing arrangements that rank below the senior debt.

• In most cases it may have certain features that allow the debt to be converted into equity

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BondsBonds• These are interest-bearing instruments issued

by companies, governments or other organisations, and sold to investors in order to raise capital. – They are a type of debt. – They tend to be long-term obligations with fixed

interest rates and repayment schedules.– They are usually issued and sold in the public bond

markets, although increasingly some are sold directly to institutional investors in which case the financing is known as a "private placement".

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7. Grants7. Grants• Are non-returnable source of funding which are

provided to projects or exporters to cover capital costs.

• Bodies, with an interest in seeing the projects developed, use grants to encourage developers to consider projects which have high risks and uncertain returns.

• They can be used in order to reduce the risk exposure of the commercial lenders and investors, or to cover incremental capital costs.

• Grant programmes have to be operated carefully in a way that will not distort market forces or lead to market collapse on withdrawal. Typically a lender will accept a maximum of 30 to 50% of the total equity requirement of a project from grant sources.

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8. Insurance and Guarantees8. Insurance and Guarantees• Not a type of funding mechanism in the strict sense• However, insurance and loan guarantees are vital

components in financing. – For any project, a full insurance package must be in place

before financing will be finalised. • Lenders will have specific insurance requirements,

and insurance documents will be part of the overall financing documentation.

• Two particular needs for insurance that are particularly relevant in the context of this work are: export insurance concerning the risks particular to doing business in other countries, and technology insurance concerning the risks particular to the performance of the technologies

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9. Ownership9. Ownership• For projects where new a new project is being

implemented independently of the local or national institutions, the legal control and ownership of the plant can be described by various acronyms. – BOO (build, own, operate) is used when ownership of the

project remains with the same company throughout its life. – BOT (build, operate, transfer) is when the project company

retains control for a time to receive profits from operational revenue, and then transfers ownership, often to the local public sector utility. Similarly for

– BOOT (build, own, operate, transfer) where ownership actually resides with the project company for a time.

– BOLT (build, own, lease, transfer) is for when the company leases control to third parties, before transferring ownership.

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10. Leverage Buyout (LBO)10. Leverage Buyout (LBO)• Takeover of a company using borrowed funds• The target company’s assets serve as security

for the loans taken out by the acquiring firm, which repays the loans out of cash flow of the acquired company

• Management may use this technique to retain control by converting a company from public to private

• A group of investors may also borrow from banks, using their own assets as collateral, to take over another firm

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Project Finance Comparison with Project Finance Comparison with Other VehiclesOther Vehicles

Financing vehicle

Similarity Dis-similarity

Secured debt Collaterized with a specific asset

Recourse to corporate assets

Subsidiary debt Possible recourse to corporate balance sheet

Asset backed securities

Collaterized and non-recourse

Hold financial, not single purpose industrial asset

LBO / MBO High debt levels No corporate sponsor

Venture backed companies

Concentrated equity ownership

Lower debt levels; managers are equity holders

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Alternative Approach to Risk Alternative Approach to Risk Mitigation in Project FinancingMitigation in Project Financing

Risk Solution

Completion Risk Contractual guarantees from manufacturer, selecting vendors of repute.

Price Risk hedging Resource Risk Keeping adequate cushion in

assessment.Operating Risk Making provisions, insurance.Environmental Risk InsuranceTechnology Risk Expert evaluation and retention

accounts.

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Alternative Approach to Risk Alternative Approach to Risk Mitigation in Project FinancingMitigation in Project Financing

Political and Sovereign Risk

• Externalizing the project company by forming it abroad or using external law or jurisdiction

• External accounts for proceeds• Political risk insurance (Expensive) • Export Credit Guarantees• Contractual sharing of political risk between lenders

and external project sponsors• Government or regulatory undertaking to cover policies

on taxes, royalties, prices, monopolies, etc• External guarantees or quasi guarantees

Interest Rate Risk Swaps and HedgingInsolvency Risk Credit Strength of Sponsor, Competence of management,

good corporate governanceCurrency Risk Hedging

Documents

Financing Decision