Topic 5 Project Financing

Project financing refers to the raising of funds for a project. Remember any project requires funding before construction work or programs and activities can be implemented. There are several questions that can be how to source funding, how to raise funds, how much to raise, how to service or repay the loan, and  When discussing project financing you will be looking at how to raise funds or finance for a particular project.

In project financing, the cash flow of the project is very important because the cash flow is indicating to the financier the source for loan repayment.

Project financing differs in three areas;

1. In conventional financing – cash flow can be mingled from different assets. Example; A creditor may look at cash flow from assets as well as resources of borrowers etc. In project cash flow are directly from project related assets alone and not others.
2. Financiers do not strictly monitor the funding given to the project promoter. In project financing, the creditor ensures proper utilization of funds and creation of assets as envisaged in the project proposal. Funds are also released in stages.
3. The creditors are not interested in monitoring the performance of the enterprise. They are interest in getting their money repaid in one way or the other.

Sources of Finance

After the project cost is ascertained, the sources of finance available for meeting the project cost are to be analysed and proper combination of the different sources shall be chosen that is most suitable for the project.

Source of Finance can be broadly divided into two categories and these are Equity Capital and Debt Capital (Borrowed Capital). The combination of equity and debt should be judiciously chosen and it will vary according to the nature of the project.

Students should remember that Debt capital enforces on the organization the obligations for loan repayment. Included in the repayment are interests already factored into the terms and conditions of the debt or loan.

Equity on the other hand provides a cushion for times when business conditions are unfavourable and operational difficulties

Listed below are main source for Project Financing

• Ordinary Shares
• Preference Shares
• Debentures
• Bonds
• Term Loans
• Deferred Credits
• Capital Investment Subsidy
• Lease Financing
• Unsecured Loans
• Internal Accruals
• Bridge Loan
• Public Deposits

Ordinary Shares – (Common or Equity Shares) are the sources of permanent capital. Here the owners of the shares (ordinary or preferences) are the legal owners of the company. The shareholders expect returns on their shares through dividends.

Preference Shares – Here shareholders bear a pre-determined rate of dividend. They have priority of claim over equity shares in the matter of dividend payments. In the case of company liquidation they get priority before the other shareholders.

Debentures – These are instruments for raising long term debt capital. The debenture holders are the creditors of the company. The company that has borrowed the money by way of debentures has the obligation to repay interest and debt on specified dates

Advantages of Debentures

1. Costs of debentures are less than cost of equity capital.
2. Interest payments to debenture holders are tax deductable.
3. Since debenture holders do not have voting rights, there is no dilution of ownership

If project earns extraordinary profit, the debenture holders are entitled to receive only interest.

Disadvantages of Debentures

Debentures imposes a legal obligation for the payment of interest and principals and if this is not paid, there is a danger of the company being forced into liquidation. When there is fluctuation in sales and earnings, this can have an impact on repayment.

Bonds – Bonds are similar to debenture and these two terms can sometimes be used interchangeably. Sometimes Bonds are terms used for public debt securities issued by the government.

Term Loans – Term Loan refers to loans offered for projects and normally the terms can range from a period of 5 to 10 years depending on the nature of the project. In Papua New Guinea, the Government has borrowed long term loans that are currently at a term of 25 to 30 years and these are mainly for major infrastructure such as Roads and Bridges, Hydro power plants, Airport infrastructure etc. Example: Tokua and Jackson airports.

Under long term loans, the loan agreement would incorporate the interest and principals repayments in the term of the loan.

Deferred Credits – Some suppliers of plant and machineries normally provide deferred credit facilities provided the credit-taker offers a Bank guarantee.

Capital Investment Subsidy – In some countries the government provides subsidy for the setting up of certain industries.

Lease Financing – Under this type of arrangements, there is a contract whereby the lessor (the owner of the assets) gives to the lessee (the user of the asset) the right to use the assets, usually for an agreed period of time. The lessee makes a periodic payment to the lessor over a period of time, normally month.

Unsecured Loans – May refers to loans being mobilized from friends or other people when there is a short fall in the means of finances. Such arrangement happens when there is a good relationship with friends and relatives.

Internal Accruals – This type of arrangement refers to the project being financed from internal cash accruals. It may happen when there is an extension or diversification to an existing company or project. Sometimes when there is shortfall in project financing, project promoters look at the option of using internal cash accruals.

Bridge Loan – Bridge loans are sanctioned by banks and financial institutions as a means of speeding up the work on any project. This option helps projects from being completed with delays.

Public Deposits – This method of financing is getting by getting funds from the public in general. In some countries this type of financing is allowed and the government issues directions on the interest rates that need to be paid on public deposits.

Roles of Financial Institutions In Project Financing

Students should remember that most projects are financed by a combination of Equity and Debt. You should also remember that equity is normally provided by the project promoter and does not incur interest. Interests are normally charged on the loans (debt) provided for projects. In most cases equity finance is normally used during the initial stage of project implementation.

In Papua New Guinea there are several Banks and financial institutions that provide loans and finance to individual and businesses. These Banks and financial institutions have their own lending requirements in term of equity to debt ratio and borrowers are normally informed on these requirements together with interest rates.

There are different approaches to lending and this is at the prerogative of the lender. Let us look at three considerations;

1. The capacity of the project to repay the loan with interest obligations out of its own cash generations.
2. The value of security offered for the loan.
3. The integrity and willingness of the borrower to repay the loan in time.

First and foremost is the ability of the project to generate sufficient revenue to service the loan. Normally if these criteria are met then the lender may provide the loan.

Covenants Attached to Lending

In most cases Banks and financial institutions that provide loans to businesses, individuals and to project promoters imposes certain conditions as per the loan or funding provided. These conditions, such as repayment schedules, term of the loan, interest payments etc. are incorporated and stipulated in the loan agreement.

The agreements in the Loan Agreements would in most cases depend on the nature of the project and the financial viability of the borrowers. According to Nagarajan (2008), some of the typical conditions that you may come across are as follows;

• The project promoter or sponsor shall offer collateral security as required by the financial institution.
• The project promoter should furnish periodic information about the project.
• The project sponsor should us the borrowed funds only for the project implementation and for the specific purposes intended.
• The project sponsor should maintain all the assets in good condition, should insure the assets against fire, burglary and natural disasters until all money owed to the lender is fully repaid.
• The project sponsor should not dispose off any of the assets of the project without the prior approval of the lender.
• The project sponsor should get the consent of the lender (Banks/Financial Institutions) before declaring dividend payments on equity shares.
• If there is unsecured loans raised for the project, this will be paid off only when loans have been paid off in full.
• If interest is paid on unsecured loan, the rate of interest should not be in access of the rate payable to the Banks and financial institutions. 

Sources: Nagarajan (2008) Project Management 3^rd Edition, New Age