FINANCING of PROJECTS - I

ETZ C414, Project Appraisal

Lecture by Dr. Omvir Chaudhry
 EQUITY DEBT
Residual claim Fixed claim of Interest and
Principal
Dividend not Interest
tax deductible tax deductible
Indefinite Fixed maturity
Control Passive

Debt Equity Ratio (The Capital Structure)

• Variability of profit before interest and

profit

– Demand Variability

– Price Variability

– Variability of input prices

– Proportion of fixed costs

• High proportion of debt

- High degree of financial leverage

- Fixed commitments

• Total risk

- Business risk + Financial risk

• If high degree of business risk
– Financial risk should be kept low

• Debt capital
– Issue of control.

• Debt capacity
– Maintains reserve borrowing power
•Tangible assets liquid resale / secondary
market, debt finance is used more
•Lenders are more willing to lend against the
tangible assets

•Use more equity when

- Tax negligible
- Business risk high
- Control not important
- Assets intangible
- Growth options
• Use more debt when

– Tax high

– Business risk low

– Control is an issue

– Assets tangible

– Few growth options

 Menu of financing Equity
capital

Preference
Equity
capital

Internal
accruals

Sources of
capital Term
loans

Debentures

Debt Working capitall

advances

Miscellaneous
sources
• Issues to be considered in financing a
project are identical to those
considered in financing a business
firm
• Two broad sources of finance
– Shareholders’ funds (Equity funds)

– Loan funds (Debt fund)

•Considerations in determining the capital
structure
- Earnings per share
- Risk
- Control
- Flexibility
- Nature of assets
• A firm should use more equity when
– The corporate tax rate is negligible
– The business risk exposure is high
– The dilution of control is not an important
issue
– The assets of the firm are mostly intangible in
nature
– The firm has many valuable growth options
• A firm should use more debt under
opposite circumstances.
• Rights of equity shareholders consist of

– The right to residual income

– The right to control

– The pre-emptive right to purchase additional

equity shares issued by the firm

– The residual claim over assets in the event of

liquidation