Deciding on how to raise money for a project?

For a company to raise finance, two things are essential - the project that the company wants to
work on and the source of finance that can raise the money needed to finance the project.

Choosing the Project:

Before even a company (a public limited company) can raise money through the various available
mechanisms, they must first decide on the projects/operations they would like to finance. This
decision is no easy task as one needs to assess the potential return of the projects vis-à-vis the
money required to be invested for each project.

Hurdle rate, the minimum rate of return expected out of the project, is used to determine whether a
capital project (a long-term project that requires capital to be invested in building/adding/improving
to a capital asset) is viable. Investment is not made if a project's predicted rate of return (also
referred to as the internal rate of return) is less than the minimum acceptable rate (hurdle rate). Goes
without saying the riskier the project, i.e. the higher the investment that a project demands, the
higher the minimum acceptable rate of return and the higher it’s the predicted rate must be for it to
get permission from the directors.

After finalising the projects they would want to invest in, the company then begins searching for
sources of investments.

Choosing the source of finance:

A company can choose to raise money by selling pieces of its control (shares/equity of the
company) or by seeking out money from those who are in the business of lending (either through
the sale of debt securities like bonds/debentures or through taking loans from investors/banks) or by
purchasing properties which provide money periodically (assets / asset-backed securities).

Equity and asset-backed securities are rarely as lucrative in daily business as debt. This is because
raising funds through the sale of equity in the company opens up the control of the business to
several members, not to mention the costs involved in going public and the inability to raise short-
term finance through the issuance of equity as and when one requires money. Asset-backed
securities, as appealing as they are for the short-term needs of the company, have the inherent
possibility of the underlying property becoming a non-performing asset (this has led to the 2008
financial crisis). Debt financing (finances risen by taking any type of loan or by selling debt
securities like bonds/debentures), on the other hand, provides companies not only the ability to meet
their short-term needs of cash flow, bill payments, etc. but also the ability to fund long-term capital
projects.

Suppose a company decides to raise finance by taking debt. Ideally, it should devise a way to
increase the maximum amount of finance by selling securities (bonds, debentures, commercial
papers, etc.) and taking loans. It is not advisable to be reliant on just one source of finance.
However, when deciding how to finance a specific project by taking debt, the decision, more often
than not, boils down to which is the best way of raising finance for the particular project - debt
securities or loans? The answer lies in the following two factors:

1. Costs involved:

When a company (public or private limited) is eyeing to raise funds through either securities or loan
from the bank, certain costs need to be factored in to determine the more suitable format for raising
finances. These are, for example, monitoring costs & due diligence costs.

Monitoring costs are the costs the investors undertake to ensure their investment is protected. They
have an impact on the way the company functions. The following are some that are considered to be
monitoring costs:
- In loans given by banks: The power/right to appoint a nominee director (a non-executive
director) on the Board of Directors. - it is a cost to the Bank as the Bank is required to go out of it’s
way to find the one suitable for that position and then exercise that right. It is also a cost to the
company, as the company is now required to entertain that particular director as opposed to a
situation where they don't have to if they haven't taken the loan from the bank.
- In loans given by the public in the form of debentures/bonds, the requirement to keep
property under the supervision of a neutral third party is referred to as a trustee (Debenture trustee).
- it is a cost to the company because the Company has to appoint a Debenture Trustee just because
is is raising finance through selling debt securities.
 - In the case of traditional loans, Companies have to deal with only a few loan providers -
Bank/Syndicate of Banks/a few financial institutions. But when the loan is raised through the sale
of debt securities, there are more than a few lenders for the company to deal with and to satisfy.
This is directly reflected in the increase of monitoring costs of the company - as it would have to
deal with a lot more people and their claim in its assets for the loan it has risen.

Due Diligence costs, associated with investors, are the costs that are related to conducting a
thorough analysis of the features of the company and the creditworthiness of the company before
extending a loan or purchasing a security. These are also the company's costs, as the company is
legally required to create documentation and comply with certain procedures before seeking out
money from a bank / the public.

2. The Rate of Interest & Risk

In term loans, provided by institutions like Banks, the rate of interest charge is fixed. This ROI is
different to the interest rate charged by the people interested in providing money to the companies
by purchasing securities. This is due to the approach taken to risk and the amount of capital
extended as loans to the company.

Banks, because they usually extend exorbitant amounts of money compared to the parts provided to
the company by individual security purchasers, they are less risk-averse. They would ordinarily
charge a higher interest from the Company. On the other hand, individual investors, since they are
in the business of selling and purchasing debt securities, are more interested in taking risks. They
determine the risk of the investment by associating it with the company's performance. If the
company is performing well, the ROI charged is low, as a lot of investors would want to be the
investors in the company with only a few bonds/debentures of the company in the market & if the
company is not performing well, the ROI charged is higher, as there will limited investors who
would want to be the investors in such a company).

It is pertinent to note two business trends that are making Banks to be more like security purchasers.
They are sub-participation and Credit Default swaps.
Sub-participation is a contractual agreement between a lender and another financial institution
wherein the downstream financial institution undertakes to pay the lender the amount given to the
borrower in exchange for the financial institution receiving all the interests and payments from the
borrower. In case of default, the lender agrees to sell the assets mortgaged under the loan and pay
the financial institution.

Credit Default Swaps are agreements between lenders and other financial institutions wherein the
downstream financial institution undertakes to pay the lender interests and other payments as &
when the borrower defaults in paying the lender. They work on the idea of ‘shorting’ the agreement
between the lender and the borrower - the financial institution becomes a substitute for the borrower
the moment default occurs. The incentive available for the financial institution is that it receives a
periodic payment from the lender for as long as the borrower doesn't default on the interest
payment.

Conclusion:

When deciding on how to finance projects, one needs to look at the hurdle rate to determine the
project and then at the costs involved, the ROI being charged, and the risk involved.