Chapter 18 Financing of Projects

Chapter 18 Financing of Projects

%utline Capital structure Menu of financing Internal accruals Equity capital Preference Prefer ence capital  

Debentures Methods of offering Ter Te r loa loans ns !or"ing !o r"ing capital ad#ances Miscellaneous sources $aising #enture capital $aising capital in international ar"ets Project financing structures Financial closure

%utline Capital structure Menu of financing Internal accruals Equity capital Preference Prefer ence capital  

Debentures Methods of offering Ter Te r loa loans ns !or"ing !o r"ing capital ad#ances Miscellaneous sources $aising #enture capital $aising capital in international ar"ets Project financing structures Financial closure

Financial Decisions are $elati#ely Easier Financing Decisions

Investment Decisions

& Financing decisions ta"e place in

& In#estent decisions ta"e place in

capital ar"ets 'hich are

real ar"ets 'hich tend to be

appro(iately perfect)

iperfect)

& !hile a"ing financial decisions*

& !hile a"ing in#estent decisions*

you can obser#e the #alue of

you ha#e to estiate the #alue of the

siilar financial assets

capital projects)

& There are #ery fe' opportunities

& There are any opportunities in the

in the real of financing that ha#e

real of capital budgeting that ha#e

an +P, that is significantly

an +P, that is significantly differe different nt

different fro -ero

fro -ero)

.i#en the intense copetition in capital ar"et* financial econoists argue that securities are fairly priced) Put differently* they belie#e that the capital ar"et is efficient)

/asic Differences bet'een Equity and Debt  

Eq E quity Equi Eq uity ty sh shar areeho hold lder erss ha ha#e #e a residual clai on the incoe and the 'ealth of the fir

Di#idend paid to equity   shareholders shareholders is not a ta( deductible payent Equity ordinarily has indefinite life Equity in#estors enjoy the prerogati#e prer ogati#e to control the affairs of the fir

Debt   Creditors 0suppliers of debt ha#e a fi(ed clai in the for of intere interest st and principal payent Interest paid to creditors creditors is a ta( deductible payent Debt has a fi(ed aturity Debt in#estors play a passi#e role 2 of course* they ipose certain restriction restrictionss on the 'ay the fir is run to protect their interest interest

3ey Factors in Deterining the Debt 4 Equity $atio The "ey factors in deterining the debt4equity ratio for a project are5   Cost +ature of assets /usiness ris"  +ors of lenders Control considerations Mar"et conditions

6 Chec"list Use more equity when

Use more debt when

The corporate ta( rate applicable

The corporate ta( rate

is negligible

applicable is high

/usiness ris" e(posure is high

/usiness ris" e(posure is

Dilution of control is not an

Dilution of control is an

lo' iportant issue

issue

The assets of the project are

The assets of the project

ostly intangible

are ostly tangible

The project has any #aluable

The project has fe'

gro'th gro'th options

options

 Sources of Finance Part 6 7ources of Finance

Internal 6ccruals

7ecurities

Ter loans

!or"ing capital ad#ances

Miscellaneous sources

  Equity

•

  Preference

•

  /onds

•

Part / 7ources of Finance

Equity

Debt

  Equity

•

  Preference

•

Ter loans

•

!or"ing capital ad#ances

•

Miscellaneous sources

•

•

  Internal accruals •

  /onds

Internal 6ccruals Internal accruals of a fir consist of depreciation aortisation*

and retained earnings) Pros & $eadily a#ailable & +o dilution of control Cons & %pportunity cost is high

Equity Capital Equity capital represents o'nership capital as equity shareholders collecti#ely o'n the copany) They enjoy the re'ards and bear the ris"s of o'nership & 6uthorised capital & Issued capital & 7ubscribed capital & Paid4up capital & Par #alue & Issue price & /oo" #alue & Mar"et #alue

$ights of Equity 7hareholders & $ight to Incoe & $ight to Control & Pre4epti#e $ight & $ight in iquidation

7hareholder ,oting

•

Majority $ule ,oting

•

Proportionate $ule ,oting

Preference Capital Preference capital represents a hybrid for of financing) It parta"es soe characteristics of equity and soe attributes of debt)

 

Equity

& Di#idend not an obligatory

Debt & Di#idend rate is fi(ed

  payent & Di#idend not a ta(4deductible

& +o #oting right

Preference Capital Pros •

+o legal obligation to pay di#idends

•

Enhances credit'orthiness

•

+o dilution of control Cons

•

Costly source

•

7"ipping preference di#idends ad#ersely affects iage

•

,oting rights under certain conditions

Debentures 0or /onds 6"in to proissory notes* debentures are instruents for raising debt finance) Debenture holders are the creditors of the copany) The obligation of a copany to'ard its debenture holders is siilar to that of a borro'er 'ho proises to pay interest and principal at specified ties) Debentures often pro#ide ore fle(ibility than ter loans as they offer greater choice 'ith respect to aturity* interest rate* security* repayent* and special features)

Features of Debentures   Trustee

•

  7ecurity

•

  Maturity

•

  $edeption

•

•

Fi(ed rate #s) floating rate

•

Ebedded options

Inno#ations in Debentures 0/onds •

Deep discount bonds

•

Con#ertible bonds

•

Floating rate bonds

•

7ecured preiu notes

•

Inde(ed bonds

6d#antages and Disad#antages of Debt Financing  Advantages •

Ta( deductibility of interest

•

+o dilution of control

•

o'er issue costs

•

Debt ser#icing burden is generally fi(ed in noinal ters

•

Tailor4ade aturity  Disadvantages

•

Fi(ed interest and principal repayent obligation

•

Increased le#erage raises the cost of equity

•

$estricti#e co#enants

Methods of %ffering There are different 'ays in 'hich a copany ay raise finances in the priary ar"et •

Public offering

•

$ights issue

•

Pri#ate placeent

•

Preferential allotent

Initial Public %ffering 0IP% The first public offering of equity shares of a copany* 'hich is follo'ed by a listing of its shares on the stoc" ar"et* is called the IP%  Benefits 6ccess to a larger pool of  

Costs   Dilution

capital   $espectability o'er cost of capital copared to pri#ate placeent   iquidity

oss of fle(ibility Disclosures and accountability Periodic costs

The IP% Process Fro the perspecti#e of erchant ban"ing the IP% process consists of four ajor phases5 •

9iring the erchant ban"ers

•

Due diligence and prospectus preparation

  Mar"eting

•

•

7ubscription and allotent

7easoned Equity %ffering For ost copanies their IP% is seldo their last public issue) 6s copanies need ore finances* they are li"ely to a"e further trips to the capital ar"et 'ith seasoned equity offerings* also called secondary offerings) !hile the process of a seasoned equity offering is siilar to that of an IP%* it is uch less coplicated) The copany ay eploy the erchant ban"ers 'ho handled the IP%) Further* 'ith the a#ailability of secondary ar"et prices* there is no need for elaborate #aluation) Finally* prospectus preparation and road sho's can be copleted 'ith less effort and tie than required for the IP%)

/ond %ffering The bond offering process is siilar to the IP% process) There are* ho'e#er* soe differences5 •

/ond offering ephasises stable cash flo's 'hereas equity offering highlights the copany:s gro'th prospects)

  7ecurity

•

•

Credit rating

•

Debenture redeption reser#e

  Trustees

•

 Summary Comparison of the arious !ethods Public

$ights

Pri#ate

Issue

Issue

Placeent

arge

Moderate

Moderate

+egligible

Preferential

•

6ount that can

6llotent Moderate

be raised •

Cost of issue

9igh

•

Dilution of

;es

+o

+egligible

+egligible

;es

Depends

7all

+o

  control •

Degree of

arge

Irrele#ant

underpricing •

Mar"et

+egati#e

+eutral

+eutral

+eutral

Ter oans Ter loans* also referred to as ter finance* represent a source of debt finance 'hich is generally repayable in less than 1< years) The "ey features of ter loans relate to 5   Currency

•

  7ecurity

•

•

Interest payent and principal repayent

  $estricti#e co#enants

•

Ter oan Procedure •

7ubission of loan application

•

Initial processing of loan application

•

6ppraisal of the proposed project

•

Issue of the letter of sanction

 6cceptance of the ters and conditions by the

•

borro'ing unit •

E(ecution of loan agreeent

•

Creation of security

•

Disburseent of loans

  Monitoring

•

!or"ing Capital 6d#ances •

Cash credits = o#erdrafts

  oans

•

•

Purchase = discount of bills

•

etter of credit

Miscellaneous 7ources •

Deferred credit

•

ease and hire purchase finance

•

>nsecured loans and deposits

•

7pecial schees of institutions

•

7ubsidies and sales ta( deferents and e(eptions

•

7hort ter loans fro financial institutions

•

Coercial paper

  Factoring

•

  7ecuritisation

•

$aising Capital in International Mar"ets   Euroar"ets

•

•

Doestic ar"ets of #arious countries

•

E(port credit agencies

Euroar"ets •

The ter euroar"ets sees to be a isnoer because they do not ha#e a physical location) Euroar"ets refer to a collection of international ban"s that help firs in raising capital in a global ar"et 'hich is beyond the pur#ie' of any national regulatory body)

•

6n Indian fir can access the euro ar"ets to raise a eurocurrency loan or issue a eurobond or issue global depository receipts or issue eurocurrency con#ertible bonds)

Eurocurrency oans •

6 eurocurrency is siply a deposit of currency in a ban" outside the country of the currency) For e(aple* a eurodollar is a dollar deposit in a ban" outside the >7)

•

The ain features of eurocurrency loans* 'hich represent the principal for of e(ternal coercial borro'ing are5   7yndication

•

•

Floating rate

•

Multi 2 currency option

•

/ullet repayent or installent repayent

Eurocurrency /onds Firs using the euroar"ets for debt financing can ta"e out loans 0called eurocurrency loans or sell bonds 0referred to as eurocurrency bonds) The iportant features of a eurocurrency bond are 5 •

It is issued outside the country in 'hose currency it is denoinated

•

It is anaged by a syndicate of ban"s

•

It is a bearer bond

•

The interest is usually paid annually or half 2 yearly)

.lobal Depository $eceipts In the depository receipts echanis* the shares issued by a fir are held by a depository* usually a large international ban"* 'ho recei#es di#idends* reports* etc) and issues clais against these shares) These clais are called depository receipts 2 in euroar"ets they are called .D$s 2 'ith each receipt being a clai on a specified nuber of shares) The underlying shares are called depository shares) The .D$s are denoinated in a con#ertible currency 2 usually >7 dollars) .D$s ay be listed and traded on ajor stoc" e(changes or ay trade in the %TC ar"et) The issuer fir pays di#idends in its hoe currency 'hich is con#erted into dollars by the depository and distributed to the holders of .D$s) This 'ay the issuing fir a#oids listing fees and onerous disclosure and reporting requireents 'hich 'ould be obligatory if it 'ere to be directly listed on the stoc" e(change) 9olders of .D$ can con#ert the into the underlying shares by surrendering the depository receipts to the depository)

Foreign Doestic Mar"ets 6 second 'ay to raise oney internationally is to sell securities directly in the doestic capital ar"ets of foreign countries) This is referred to as direct issuance) For e(aple* a /ritish fir ay issue dollar4denoinated equity stoc"s in the >)7) capital ar"et or a .eran fir ay issue yen4denoinated bonds in the ?apanese capital ar"et) 6 foreign issuer has to satisfy all regulations applicable to doestic firs) In addition* it ay be required to fulfill certain special obligations applicable to foreign issuers) Indian firs can also issue bonds and equities in the doestic capital ar"et of a foreign country) In recent years* Indian firs ha#e tapped the doestic capital ar"ets of countries li"e the >7* ?apan* >3* and 7'it-erland)

>7 Capital Mar"et The >7 capital ar"et is the largest national capital ar"et* copleented by a #ery acti#e deri#ati#es ar"et) The ost prestigious funding option in the >7 ar"et is a public issue of ;an"ee /onds 0dollar denoinated bonds issued in the >7 capital ar"et by foreign borro'ers) 6 public issue of ;an"ee bonds has to coply 'ith stringent listing requireents of the 7EC in the >7) ;an"ee bonds can also be offered on a pri#ate placeent basis to @I/s 0qualified institutional buyers  under 'hat is popularly "no'n as rule 1AA6) 7uch bonds do not ha#e to coply 'ith the stringent listing requireents under the 7ecurities 6ct* 1B) $eliance Industries iited 'as perhaps the first Indian copany to issue ;an"ee bonds in the >7 6part fro tapping the >7 bond ar"et* Indian copanies can raise funds in the >7 equity ar"et by issuing 6erican Depository 7hares 06D7s) i"e .D$s* 6D7s represent clais on a specific nuber of shares) The principal difference bet'een the t'o is that the .D$s are issued in the euroar"et 'hereas 6D7s are issued in the >7 doestic capital ar"et)

%ther Mar"ets /esides the >7 doestic capital ar"et* Indian copanies ha#e tapped the doestic capital ar"ets of other countries such as ?apan and >3* issuing ainly debt instruents such as 7aurai /onds 0publicly issued bonds in the ?apanese ar"et* 7hibosai /onds 0pri#ately issued bonds in the ?apanese ar"et* /ulldog /onds 0>3 ar"et* and $ebrant /onds 0Dutch ar"et)

E(port Credit 7chees E(port credit agencies ha#e been established by the go#ernents of ajor industrialised countries for financing e(ports of capital goods and related technical ser#ices) The proinent e(port credit agencies are >7 EIM* ?EIM* 9E$ME7* and C%F6CE) These agencies follo' certain consensus guidelines for supporting e(ports under a con#ention "no'n as the /erne >nion) 6s per these guidelines* the interest rate applicable for e(port credits to Indian copanies for #arious aturities are regulated) T'o "inds of e(port credit are pro#ided 5 buyer:s credit and supplier:s credit) /uyers Credit This is a credit pro#ided directly to the Indian buyer for purchase of capital goods and=or technical ser#ices

fro the o#erseas

e(porter 7upplier:s Credit This is the credit pro#ided to the o#erseas e(porters so that they can a"e a#ailable ediu 2 ter finance to Indian iporters

7alient Features of Finance Pro#ided by E(port Credit 6gencies The finance is tied to iport of goods and ser#ices >p to 8 percent of the #alue of iports is a#ailable as finance) The finance is a#ailable for long tenors at reasonable cost) E(port credit agencies insist on ban" guarantee)

Full $ecourse 7tructure •

If a ne' copany is set up for ipleenting the project* the borro'ings are fully secured by a first charge on the assets)

•

If the project is ipleented as an e(pansion or di#ersification project of an e(isting copany* 'hich already has lenders 'ith charge on assets* lenders for the ne' project get a pari  passu charge on the entire bloc" of assets)

•

Cash flo's fro the e(isting as 'ell as the proposed acti#ities are considered to judge the debt ser#icing ability)

•

Personal guarantee and = or corporate guarantee is gi#en)

iited $ecourse 7tructure Pri#ate sector participation in infrastructure projects is accopanied by a liited recourse cash4flo' based financing structure) The salient features of this structure are5 •

The project is set up as a separate copany* called a 7pecial Purpose ,ehicle 07P,

•

The security pac"age for the lenders includes a registered ortgage = hypothecation of all assets* a pledge of sponsor holdings in the 7P,* an assignent of all project contracts

•

and docuents* and a charge on future recei#ables) The cash flo' of the 7P, is allocated in a pre4deterined anner to #arious requireents including debt ser#icing

•

•

enders do not ha#e recourse to the sponsors and their other businesses /eing a separate entity* the 7P, is ban"ruptcy reote fro the other businesses of the sponsor)

Financial Closure •

Financial closure eans that all the sources of funds required for the project ha#e been tied up)

•

In general* financial closure is achie#ed soon 'hen5 •

7uitable credit enhanceent is done to the satisfaction of lenders)

•

6dequate under'riting arrangeents are ade for ar"et4related offerings)

•

The resourcefulness of the prooters is 'ell established)

•

The process is started early and concurrent appraisal is initiated if se#eral lending agencies are in#ol#ed)

7uary 6 capital project ay be regarded as a ini4fir) 7o the issues to be considered in financing a project are identical to those considered in financing a business fir) 6lthough the nuber of cople( and e(otic financing instruents is e(panding* the financing decision* copared to the in#estent decision* is relati#ely easier to a"e and has a lesser ipact on #alue) The t'o broad sources of finance a#ailable to a fir are 5 shareholders: funds 0equity funds and loan funds 0debt funds) The "ey factors in deterining the debt4equity ratio for a project are5 cost* nature of assets* business ris"* nors of lenders* control considerations* and ar"et conditions) 6 fir should use ore equity 'hen the corporate ta( rate is negligible* the business ris" e(posure is high* the dilution of control is not an iportant issue* the assets of the fir are ostly intangible in nature* and the fir has any #aluable gro'th options) The fir should use ore debt under opposite circustances)

!hen a copany is fored* it first issues equity shares to the prooters 0founders and also* in ost cases* to a select group of in#estors) 6s the copany gro's* it ay rely on the follo'ing ethods of raising equity capital 5 initial public offering* seasoned offering* rights issue* pri#ate placeent* and preferential allotent) The internal accruals of a fir consist of depreciation charges and retained earnings) Equity and debt coe in a #ariety of fors and are raised in different 'ays Equity capital represents o'nership capital as equity shareholders collecti#ely o'n the fir) Equity shareholders enjoy the re'ards as 'ell as bear the ris" of o'nership) The rights of equity shareholders consist of 5 0i the right to residual incoe* 0ii the right to control* 0iii the pre4epti#e right to purchase additional equity shares issued by the fir* and 0i# the residual clai o#er assets in the e#ent of liquidation) The first public offering of equity shares of a copany* 'hich is follo'ed by a listing of its shares on the ar"et* is called an initial public offering 0IP%) 6 public issue by a listed copany is called a seasoned offering) 6 rights issue in#ol#es selling securities in the priary ar"et by issuing rights to the e(isting shareholders) Pri#ate placeent and preferential allotent in#ol#e sale of securities to a liited nuber of sophisticated in#estors such as financial institutions* utual funds* #enture capital funds* ban"s* and so on)

Preference capital represents a hybrid for of financing 2 it parta"es soe characteristics of equity and soe attributes of debentures) For large firs* debentures are a #iable alternati#e to ter loans) Debentures are instruents for raising debt finance) Debentures often pro#ide ore fle(ibility than ter loans as they offer greater choice 'ith respect to aturity* interest rate* security* repayent* and special features) Than"s to the latitude enjoyed by copanies* a #ariety of debt instruents li"e deep discount bonds* con#ertible debentures* floating rate bonds* secured preiu notes* and inde(ed bonds ha#e been eployed) Ter loans represent a source of debt finance 'hich is generally repayable in less than 1< years) They are eployed to finance acquisition of fi(ed assets and 'or"ing capital argin) Financial institutions gi#e rupee ter loans as 'ell as foreign currency ter loans) Ter loans represent secured borro'ing) >sually assets* 'hich are financed 'ith the ter loan* pro#ide the prie security) %ther assets of the fir ay ser#e as collateral security) The principal aount of a ter loan is generally repayable o#er a period of A to  years after an initial grace period of 1 to G years) In order to protect their interest* financial institutions ipose restricti#e co#enants on the borro'ers)

Financial institutions appraise a project fro the ar"eting* technical* financial* econoic* and anagerial angles) !or"ing capital ad#ance by coercial ban"s represents the ost iportant source for financing current assets) !or"ing capital ad#ance is pro#ided by coercial ban"s in three priary 'ays 5 0i cash credits=o#erdrafts* 0ii loans* and 0iii purchase=discount of bills) 6part fro the principal sources li"e equity* internal accruals* ter loans* debentures* and 'or"ing capital ad#ance there are se#eral other 'ays in 'hich finance ay be obtained) These include deferred credit* lease finance* hire purchase* unsecured loans and deposits* special schees of institutions* subsidies* sales ta( deferents and e(eptions* coercial paper* factoring and securitisation) 6 young copany that is not yet ready or 'illing to tap the public financial ar"et ay see" #enture capital 'hich represents financial in#estent in a ris"y proposition ade in the hope of earning a high rate of return) Than"s to globalisation of capital ar"ets* Indian firs can raise capital fro euroar"ets or fro the doestic ar"ets of #arious countries or fro e(port credit agencies)

Euroar"ets refer to a collection of international ban"s that help firs in raising capital in a global ar"et 'hich is beyond the pur#ie' of any national regulatory body) 6n Indian fir can access the euroar"ets to raise a eurocurrency loan or issue a eurobond) Eurocurrency loans* 'hich represent the principal for of e(ternal coercial borro'ings are syndicated loans carrying a floating rate generally lin"ed to I/%$) !hile the eurocurrency loan is the ost popular for of e(ternal coercial borro'ing* Indian firs also raise oney by issuing eurocurrency bonds 0or notes) Fro early 1BB