Factors to be kept in mind while doing Project Financing – An Analysis
Factors to be kept in mind while doing Project Financing, Things to Consider Before You Make Investing Decisions. When we are up to doing project financing for an organization, many things have to be kept in mind. There are three major considerations, i.e. risk, cost of capital and control, which help the finance manager in determining the proportion in which he can raise funds from various sources.
Although, three factors, i.e., risk, cost and control determines the capital structure of a particular business undertaking at a given point of time, the capital structure is sought to be designed in such a manner so as to minimize the risk, cost and loss of control. Now check more details about “Factors to be kept in mind while doing Project Financing” from below…
Factors to be kept in mind while doing Project Financing
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Risk is of two kinds, i.e., Financial risk and Business risk. Here we are concerned primarily with the financial risk. Financial risk also is of two types:
Risk of cash insolvency:
Increase in debt implies increase in risk of cash insolvency. This is due to two reasons:
(a) Higher proportion of debt in the capital structure increases the commitments of the company with regard to fixed charges.
(b) The possibility that the supplier of funds may withdraw the funds at any given point of time. Thus the long-term creditors may have to be paid back in installments, even if sufficient cash to do so does not exist. This risk is not there in the case of equity shares.
Risk of variation in the expected earnings available to equity share holders:
Higher debt content in capital structure implies higher risk of variations in expected earnings available to equity shareholders. This is because of trading on equity. The relative fluctuation of expected equity earnings will be greater if the capital structure has high debt content.
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2. Cost of Capital
It is obvious that a business should be at least capable of earning enough revenue to meet its cost of capital and finance its growth. Hence, along with the risk as a factor, the finance manager has to consider the cost aspect carefully while determining the capital structure.
- When a company issues further equity shares, it automatically dilutes the controlling interest of the present owners.
- Preference shareholders can have voting rights and thereby affect the composition of the Board of directors in case dividends on such shares are not paid for two consecutive years.
- Financial institutions normally stipulate that they shall have one or more directors on the Board. Hence, when the management agrees to raise loans from financial institutions, by implication it agrees to forego a part of its control over the company.
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4. Trading on Equity
A company may raise funds either by the issue of shares or by borrowings. Borrowings carry a fixed rate of interest and this interest is payable irrespective of fact whether there is profit or not. Of course, preference shareholders are also entitled to a fixed rate of dividend but payment of dividend is, subject to the profitability of the company. In case the return on investment is more than the rate of interest on borrowed funds or rate of dividend on preference shares, it is said that the company is trading on equity.
In simpler terms, trading on equity implies that one borrows at a lower rate and invests the same funds in the business to earn a higher rate.
5. Corporate Taxation
- Dividend on shares is not a tax deductible expense.
- Interest paid on borrowed capital is allowed as deduction.
- Cost of raising finance through borrowing is deductible in the year in which it is incurred. If it is incurred during the pre-commencement period, it is to be capitalized.
- Cost of issue of shares is allowed as deduction.
Owing to the above provisions corporate taxation plays an important role in determining the choice between different sources of financing.
6. Government policies
Monetary policies, fiscal policies, lending policies, rules and regulations of capital markets, tax benefits, etc. all have an impact on the capital structures of an entity. Only after taking into consideration the above facts, proper project financing can be done.