--- title: "Project finance; sound capital structure; factors" subject: "Project Engineering" chapter: 6 key: "semester_7/project_engineering:project-finance-features-sound-capital-structure" source: https://www.bctengineer.com/q/semester_7/project_engineering/project-finance-features-sound-capital-structure site: BCT Engineering --- # Project finance; sound capital structure; factors Project Engineering · Chapter 6: Introduction to Project Financing - Asked in: 2072 Kartik; 2074 Asoj, 1+2 marks (asked 2 times) - Video: [Features Of A Sound Capital Structure](https://www.youtube.com/watch?v=IrfFsrW2zHo) — Eeducom - Answer checked by Claude Opus 5.5 (high effort) on 2026-10-14 - Page: https://www.bctengineer.com/q/semester_7/project_engineering/project-finance-features-sound-capital-structure - Whole chapter: https://www.bctengineer.com/md/semester_7/project_engineering/chapter-6 ## Question Explain the term 'project finance' and describe the features of a sound capital structure. Write down and explain with an example what are the factors to be considered to take a capital structure decision. ## Short answer Project finance uses an SPV, with debt repayment from project cash flows. A sound capital structure is profitable, solvent, flexible, conservatively levered, and legally compliant. Key decision factors: cash flow stability, leverage, cost of capital, control, and risk. Example: Rs 10 crore investment, 20% return, using 60% debt at 10% boosts EPS from Rs 15 (all-equity) to Rs 26.25. ## Answer #### 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. ## Check yourself The answer's key points as multiple-choice questions, with the correct option and why. 1. Which pair is a feature of a sound capital structure? A. Maximum debt and no flexibility B. Solvency and flexibility C. Complexity and high risk D. Loss of owner control and illiquidity Answer: B. A sound structure is simple, profitable, solvent, flexible, controlled, conservative, liquid and legal. (Key point: Sound structure features) 2. What does flexibility mean in capital structure? A. All borrowing capacity is used at once B. Structure can never be changed C. Structure can be changed when needs change, with spare borrowing capacity D. Only equity is allowed Answer: C. A flexible structure retains unused borrowing capacity for future needs. (Key point: Flexibility) 3. In the example (EBIT Rs 2 crore, 25% tax), what is EAT with Rs 6 crore debt at 10%? A. Rs 1.5 crore B. Rs 1.4 crore C. Rs 0.6 crore D. Rs 1.05 crore Answer: D. Interest = 0.6; EAT = (2 - 0.6) x 0.75 = 1.05 crore. (Key point: EPS example) 4. In that example, which plan gives higher EPS and why? A. Debt plan, Rs 26.25, because ROI (20%) exceeds interest (10%) B. All-equity plan, Rs 15, because debt is costly C. Both give the same EPS D. All-equity plan since fewer shares exist Answer: A. The debt plan has only 4 lakh shares and EAT of 1.05 crore giving EPS 26.25 against 15; but financial risk rises. (Key point: EPS comparison) ## Related in Project Engineering - [Project finance sources; capital structure determinants](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Aproject-finance-sources-capital-structure-determinants) — Project Engineering, chapter 6, asked 3× - [Features of a sound capital structure](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Acapital-structure-features-sound) — Project Engineering, chapter 6 - [Project financing; structures; capital structure steps](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Aproject-finance-define-structures-steps) — Project Engineering, chapter 6 - [Finance sources; capital budgeting steps; NPV](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Asources-project-finance-steps-capital-budgeting) — Project Engineering, chapter 6 - [Sources of finance; ARR, payback, IRR, PI decision](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Aproject-finance-sources-investment-decision-c75) — Project Engineering, chapter 6 - [Preference shares; determinants of capital structure](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Asources-project-finance-preference-shares) — Project Engineering, chapter 6