Project finance; sound capital structure; factors

Project finance

Project finance is the long-term financing of a specific project (such as a hydropower plant, road or pipeline) in which the lenders and investors look mainly at the cash flow and assets of the project itself, not at the balance sheet of the sponsors, for repayment of the debt and return on equity. A separate legal entity (special purpose vehicle, SPV) is usually formed for the project.

Features of a sound capital structure

1. Simplicity: easy to understand and manage.
2. Profitability: gives maximum return to shareholders at minimum cost of capital.
3. Solvency: debt is within the firm's ability to pay interest and principal.
4. Flexibility: can be changed when needs change, with spare borrowing capacity.
5. Control: keeps control with the existing owners.
6. Conservatism: does not take excess debt, risk is kept low.
7. Liquidity and marketability: securities can be sold easily in the market.
8. Adequate capital: enough funds for fixed and working capital.
9. Legal compliance: follows the Companies Act and regulatory limits.

Factors to be considered in the capital structure decision (with example)

1. Cash flowability: the ability to generate enough cash to pay interest and repay debt. Stable, high cash flow allows more debt (measured by interest coverage and debt service coverage ratio).
2. Leverage / trading on equity: if the return on investment is higher than the interest rate, more debt increases EPS; if lower, it reduces it.
3. Cost of capital: debt is cheaper because interest is tax deductible; the structure with the lowest weighted average cost of capital is preferred.
4. Control: issuing new equity dilutes the control of existing owners, so they may prefer debt.
5. Flexibility: the firm should keep unused borrowing capacity for future needs.
6. Marketability and timing: condition of the capital market, investor demand, and the best time for share or bond issue.
7. Size and stage of the firm: large, established firms have easier access to debt and equity.
8. Nature of the business: stable-demand projects (e.g. hydropower with PPA) can carry more debt than cyclical businesses.
9. Legal and tax factors: limits on debt-equity ratio by regulators, tax rate, covenants of lenders.
10. Risk (business and financial): high business risk needs less debt.

Example: a company needs Rs 10 crore. It can raise it by (a) all equity, or (b) Rs 6 crore debt at 10% and Rs 4 crore equity. With EBIT = Rs 2 crore, tax 25%:

$$\begin{aligned} \text{(b) interest} &= 6 \times 10\% = 0.6\ \text{crore}, \quad EAT = (2 - 0.6)\times 0.75 = 1.05\ \text{crore}\\ \text{(a) EAT} &= 2 \times 0.75 = 1.5\ \text{crore} \end{aligned}$$

With shares of Rs 100, (a) has 10 lakh shares, EPS = Rs 15; (b) has 4 lakh shares, EPS = Rs 26.25. Because the return on investment (20%) is higher than the interest (10%), debt raises EPS (leverage). But it would also increase financial risk if the EBIT fell, which is why cash flowability and the other factors must be checked.