--- title: "Project finance sources; capital structure determinants" subject: "Project Engineering" chapter: 6 key: "semester_7/project_engineering:project-finance-sources-capital-structure-determinants" source: https://www.bctengineer.com/q/semester_7/project_engineering/project-finance-sources-capital-structure-determinants site: BCT Engineering --- # Project finance sources; capital structure determinants Project Engineering · Chapter 6: Introduction to Project Financing - Asked in: 2080 Bhadra, 2+4 marks; 2073 Shrawan, 3+5 marks; 2070 Chaitra (old course), 2+6 marks (asked 3 times) - Video: [Capital Structure | Meaning | Theories | Determinants | Features | Financial Management | Part-26](https://www.youtube.com/watch?v=uMDZi-3moiw) — Accounting MasterClass - 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-sources-capital-structure-determinants - Whole chapter: https://www.bctengineer.com/md/semester_7/project_engineering/chapter-6 ## Question Define the term project finance. What are the sources of financing in any project? Write down and explain the determinants of the capital structure decision to be undertaken for an investment proposal. ## Short answer Project finance funds a standalone project via an SPV, repaid from project cash flows. Financing sources include equity, debt, grants, and supplier credit. Capital structure determinants: cash flow stability, leverage effect, cost of capital, control, flexibility, market timing, business risk, and legal limits. ## 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. Main features: a separate project company (SPV), non-recourse or limited-recourse debt, a high debt-equity ratio, cash flow as the basis of repayment, risk sharing among many parties through contracts, and a long term. #### Sources of financing | Type | Sources | |---|---| | Equity | Ordinary shares, sponsors' equity, retained earnings, public issue (IPO) | | Quasi-equity | Preference shares, convertible debentures | | Debt (long term) | Bank and financial institution loans, debentures/bonds, syndicated loans, term loans | | Government / donors | Government grants and budget, soft loans from ADB, World Bank, JICA, Exim banks, bilateral aid | | Others | Supplier's credit, leasing, venture capital, public-private partnership (PPP), build-operate-transfer (BOT), community and user contributions, remittance/pooled funds | #### Determinants of capital structure decision 1. **Cash flowability:** the ability to generate enough cash to pay interest and repay debt. Stable, high cash flow allows more debt (measured by the interest coverage and debt service coverage ratios). 2. **Leverage / trading on equity:** if the return on investment is higher than the interest rate, more debt increases EPS; if it is lower, more debt reduces EPS. 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:** the condition of the capital market, investor demand, and the best time for a 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 a PPA) can carry more debt than cyclical businesses. 9. **Legal and tax factors:** limits on the debt-equity ratio set by regulators, the tax rate, and lenders' covenants. 10. **Risk (business and financial):** a business with high business risk should use less debt. **Example:** a hydropower project with a long-term power purchase agreement has a stable cash flow, so it can use about 70:30 debt-equity; a project with uncertain revenue should use less debt. ## Check yourself The answer's key points as multiple-choice questions, with the correct option and why. 1. What is project finance? A. Short-term loan based on the sponsors' balance sheet B. Long-term financing where lenders look mainly at the project's own cash flow and assets, usually through an SPV C. Government grant with no repayment D. Financing only through ordinary shares Answer: B. Project finance relies on the project's cash flow and assets, not the sponsors' balance sheet, usually via an SPV. (Key point: Project finance meaning) 2. Which are quasi-equity sources? A. Term loans and syndicated loans B. Government grants and budget C. Preference shares and convertible debentures D. Ordinary shares and retained earnings Answer: C. Preference shares and convertible debentures lie between equity and debt. (Key point: Quasi-equity) 3. How does cash flowability affect capital structure? A. High cash flow means no debt should be used B. Cash flow has no effect on debt C. Unstable cash flow allows the highest debt D. Stable high cash flow allows more debt, measured by interest coverage and DSCR Answer: D. Stable cash flow can support interest and repayment so more debt can be used. (Key point: Cash flowability) 4. When does more debt increase EPS? A. When the return on investment is higher than the interest rate B. When the return on investment is lower than the interest rate C. Only when taxes are zero D. Never, debt always lowers EPS Answer: A. Trading on equity raises EPS when ROI exceeds the cost of interest. (Key point: Leverage) ## Related in Project Engineering - [Project finance; sound capital structure; factors](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Aproject-finance-features-sound-capital-structure) — Project Engineering, chapter 6, asked 2× - [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 - [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 - [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 - [Capital structure planning importance, determinants](https://www.bctengineer.com/question.md?key=semester_7%2Fproject_engineering%3Acapital-structure-planning-importance-determinants) — Project Engineering, chapter 6 ## Related in other subjects - [IRR by trial and error; investment decision](https://www.bctengineer.com/question.md?key=semester_6%2Fengineering_economics%3Airr-trial-error-25000) — Engineering Economics, chapter 3