Project Financing,

Capital Planning
and Budgeting
PREPARED BY
ASMITA SUBEDI

1
 Project financing is the long term financing of
infrastructures and industrial projects based upon
the projected cash flows of the project rather

Project than the balance sheets of the project sponsors.

Financing Project financing refers to financing in which

lenders to a project look primarily to the cash flow
(revenues) and assets of the project as the
source of payment of their loans.

2
Project Financing vs Conventional Financing
In case of conventional financing, creditor makes an assessment of repayment of his loan by
looking all the cash flows and resources from the borrower whereas in case of project financing,
cash flow from the project related assets alone are considered for assessing the repaying
capacity.

In conventional financing, end use of the borrowed funds is not strictly monitored by the lenders.
In project financing, creditors ensure proper utilization of funds and creation of assets as
foreseen in project proposal.

In conventional financing, creditors are not interested in monitoring the performance of the
enterprise and they are only interested in their money getting repaid in one way or the other.
Project financiers are keen to watch the performance of the enterprise and suggest/take remedial
measures as and when required to ensure that project repays the debt out of its cash generation

3
 Capital budgeting may be defined as the
firm's decision to invest its current funds
most efficiently in long term activities in
anticipation of an expected flow of future
Capital benefit over a series of years.
Budgeting The long term activities are those activities
which affects firms' operations beyond the
one year period.

4
 Investment can be in fixed or current assets

Investments in the fixed assets, which have long terms implications

for the firms in terms of expenditure and benefit is evaluated as
capital budgeting decision.

The capital budgeting excludes investment required for current

Nature of assets.

investment It includes following types of investment:

decisions Addition, dispostition, modifications and replacement of assets in a
long term basis.

Introducing a new product

Expanding the business

5
Features of Capital Budgeting

The exchange of the current funds for future benefits (I.e funds are invested only for future benefits)

Funds are invested in long term activities

The future benefits will occur to the firm over a series of years (I.e funds are only invested only if future
benefits occur over a series of years)

6
 They have long term implications for the firm
and influence its risks complexion

Importance They involve commitment of large amount of

funds
of Capital They are irreversible decisions

Budgeting They are among the most difficult decision to

be made

7
Capital Budgeting Process

1 2 3 4
Project Project Project Project
Generation Evaluation Selection Execution

8
Project Generation

Project generation is the development of proposal for investment

decision

The proposal may focus in adding new equipment for increasing the
rate of production or it may focus to reduce the cost of production

9
 Project evaluation is done by expert groups
Following points needs to be considered:
Project Estimate on cash flow
Evaluation Selection criteria to judge the project
viability
Estimated benefit over cost.

10
Project Selection

No standard administrative procedure can be laid down for selecting the project and approving the
investment proposal.

The screening and selection procedure may vary from firm to firm

Projects are screened at multiple levels

11
Project Execution

After the final selection of the investment proposal, the funds are appropriated for capital expenditure.

The formal plan for appropriation of funds is called capital budget

Such plans are prepared or approved by project execution committee or the top managemtn.

12
Investment Decision Criteria

It should provide a ranking of projects in order of their desirability ( viability)

It should also solve the problem of choosing among alternative projects

It should be criterion which is acceptable to any conceivable investment project

It should recognize the fact that bigger benefit are preferable to smaller ones, and early benefits are
preferable to later benefits

It should provide a means of distinguishing between acceptable and unacceptable projects.

13
Traditional Criteria

Payback period Accounting Rate of Return

Simple payback period
Discounted payback period

14
Discounted Cash Flow (DCF) Criteria

Net present value/Net future value/ Net annual value

Internal rate of return
Profitability index or B/C ratio

15
 Money has a time value.

—Capital refers to wealth in the form of money or

property that can be used to produce more
Time Value wealth.

of Money —Engineering economy studies involve the

commitment of capital for extended periods of
time.

—A dollar today is worth more than a dollar one or

more years from now (for several reasons).

16
Simple interest
When the total interest earned or charged is
linearly proportional to the initial amount of the
loan (principal), the interest rate, and the
number of interest periods, the interest and
interest rate are said to be simple.

17
Calculation of simple interest
The total interest, I, earned or paid may be computed
using the formula below.

I = P* N* i

P = principal amount lent or borrowed

N = number of interest periods (e.g., years)

i = interest rate per interest period

The total amount repaid at the end of N interest

periods is P + I.
18
Compound
Interest
Compound interest reflects
both the remaining principal
and any accumulated
interest. For $1,000 at 10%…

19
Economic Equivalence
Economic equivalence allows us to compare
alternatives on a common basis.

Each alternative can be reduced to an equivalent basis

dependent on
◦ interest rate,
◦ amount of money involved, and
◦ timing of monetary receipts or expenses.

Using these elements we can “move” cash flows so

that we can compare them at particular points in time

20
 i = effective interest rate per interest period

N = number of compounding (interest) periods

P = present sum of money; equivalent value of

one or more cash flows at a reference point in
time; the present
Economic F = future sum of money; equivalent value of one
Equivalence or more cash flows at a reference point in time;
the future

A = end-of-period cash flows in a uniform series

continuing for a certain number of periods,
starting at the end of the first period and
continuing through the last
21
Economic Equivalence

22
 Using the standard notation, we find that a present
amount, P, can grow into a future amount, F, in N time

Economic Equivalence periods at interest rate I

23
Economic
Equivalence

24
Economic
Equivalence

25
Economic
Equivalence

26
Economic
Equivalence

27
Economic
Equivalence

28
29
Economic
Equivalence

30
Economic Equivalence
31
Nominal
and Effective
Interest
Rates

32
Nominal and Effective Interest Rates

33
Nominal and Effective
Interest Rates
34
Nominal and Effective
Interest Rate
35
 Present Worth (PW)

Future worth (FW)

Annual worth (AW)

Evaluating a
single project
Internal rate of return (IRR)

External rate of return (ERR)

Payback period (generally not appropriate as a primary

decision rule)

36
Evaluating a
single project
To be attractive, a capital project
must provide a return that
exceeds a minimum level
established by the
organization. This minimum level is
reflected in a firm’s Minimum
Attractive Rate of Return(MARR).

37
 The present worth (PW) is found by
discounting all cash inflows and outflows to
the present time at an interest rate that is
Present Worth generally the MARR.
Method
A positive PW for an investment project
means that the project is acceptable (it
satisfies the MARR).

38
 Considers all cash flow

Advantages
of Net True measure of profitability

Present Value
Recognizes the time value of
money

39
 Requires estimation of cash inflow and
outflow, which is tedious job
Disadvantages
Sensitive to discount rate
of Net Present
Value Requires computation of the opportunity
cost of the capital or MARR which are
difficult concept

40
 Consider a project that has an
initial investment of $50,000 and
Present Worth that returns $18,000 per year for
Example the next four years. If the MARR
is 12%, is this a good
investment?

41
 • Looking at FW is appropriate since the
primary objective is to maximize the future
wealth of owners of the firm.

Future • FW is based on the equivalent worth of all

Worth cash inflows and outflows at the end of the

study period at an interest rate that is
generally the MARR.
(FW)
• Decisions made using FW and PW will be
the same.

49
 A $45,000 investment in a new conveyor
system is projected to improve throughput
Future worth and increasing revenue by $14,000 per year
for five years. The conveyor will have an
example. estimated market value of $4,000 at the end
of five years. Using FW and a MARR of
12%, is this a good investment?

50
 • Annual worth is an equal periodic series of
amounts that is equivalent to the cash
inflows and outflows, at an interest rate that
Annual Worth is generally the MARR.

(AW) • The AW of a project is annual equivalent

revenue or savings minus annual equivalent
expenses, less its annual capital recovery
(CR) amount.

51
Capital recovery reflects the capital
cost of the asset.
• CR is the annual • The CR covers the
equivalent cost of the following items. – Loss in
capital invested. value of the asset.

• The CR distributes the

– Interest on invested initial cost (I) and the
capital (at the MARR). salvage value (S) across
the life of the asset.

52
Numerical Example
A project requires an initial investment of $45,000, has a
salvage value of $12,000 after six years, incurs annual
expenses of $6,000, and provides an annual revenue of
$18,000. Using a MARR of 10%, determine the AW of this
project.

53
Internal Rate of Return
• Theinternal rate of return (IRR) method is the
most widely used rate of return method for
performing engineering economic analysis.
• It is also called the investor’s method, the
discounted cash flow method, and the profitability
index.
• If the IRR for a project is greater than the MARR,
then the project is acceptable.

54
 The IRR is the interest rate that equates the equivalent
worth of an alternative’s cash inflows (revenue, R) to
the equivalent worth of cash outflows (expenses, E).

The IRR is sometimes referred to as the breakeven

How the interest rate.

IRR works The IRR is the interest i'% at which

55
 The IRR is the interest rate that equates the equivalent
worth of an alternative’s cash inflows (revenue, R) to
the equivalent worth of cash outflows (expenses, E).

The IRR is sometimes referred to as the breakeven

How the interest rate.

IRR works The IRR is the interest i'% at which

56
 Considers all cash flow

True Measure of Profitability

Advantages
of IRR Recognizes the time value of money

Consistent with the wealth maximization

principle

57
Requires estimation of cash inflow
and outflow, which is tedious job
Disadvantages
It is difficult to understand and use in
of IRR
practice as it involves complicated
computational problems.

58
59
• The IRR assumes revenues generated are reinvested
at the IRR—which may not be an accurate situation. Reinvesting
revenue-
• The ERR takes into account the interest rate, ε,
external to a project at which net cash flows generated
External
Rate of
(or required) by a project over its life can be reinvested
(or borrowed). This is usually the MARR.

Return
• If the ERR happens to equal the project’s IRR, then
using the ERR and IRR produce identical results. (ERR)

60
• Discount all the net cash outflows to
time 0 at ε% per compounding period.

• Compound all the net cash inflows to The ERR

period N at at ε%.
procedure
• Solve for the ERR, the interest rate that
establishes equivalence between the two
quantities.

61
62
63
Payback Period

The simple payback period is the number of years required for

cash inflows to just equal cash outflows.

It is a measure of liquidity rather than a measure of profitability.

64
Payback Period

65
 Simple to understand and easy to calculate

It costs less than most of the sophisticated techniques which

Advantages requires lots of analysis time and the use of computers

of Payback A company can have more favorable short run effect on earning
per share by setting up a shorter payback period

Period The riskiness of the project can be tackled by having the shorter
payback period as it may ensure guarantee against loss

It gives insight to the liquidity of the project. The funds so released

can be put to other users.

66
 It fails to take account of the cash inflow
earned after the payback period
It doesn’t consider the entire cash inflow
yielded by the project

Disadvantages Fails to consider the pattern of cash inflow in

terms of magnitude and time
of Payback
Administrative difficulties may be faced in
Period determining the maximum acceptable
payback period
Payback period method is not consistent
with the objective of maximizing the market
value of the firm's share.
67
 ARR = Average Income/ Average Investment

Average income = (income – expenses –

Accounting taxes)/ number of years

Rate of Return Average investment = ( Original investment

+ Salvage or scrap value)/2

68
 Simple to understand and easy to calculate

Advantages It cost less than most of the sophisticated

techniques which require a lots of analysis time
and use of computers.

of ARR
method It can be readily calculated using accounting data

It uses the entire stream of income in calculating

the accounting rate

69
 It ignores the time value of money. Profit occurring in
different periods are valued equally.

It uses accounting profit, not cash flows in appraising the

Disadvantages project

of ARR
It does not consider the length of the project lives

It does not allow the fact that the profit can be re invested

method It is incompatible with the firm's objective of maximizing the

market value of the share. Share value does not depend on
the accounting rate.

70
 Numerical Problem
Best Flight, Inc., is considering three mutually exclusive
alternatives for implementing an automated passenger
check-in counter at its hub airport. Each alternative meets
the same service requirements, but differences in capital
investment amounts and benefits (cost savings) exist
among them. The study period is 10 years, and the useful
lives of all three alternatives are also 10 years. Market
values of all alternatives are assumed to be zero at the end
of their useful lives. If the airline’s MARR is 10% per year,
which alternative should be selected in view of the cash-flow
diagrams shown

71
Numerical
The Consolidated Oil Company must install antipollution equipment
in a new refinery to meet federal clean-air standards. Four design
alternatives are being considered, which will have capital investment

Problem and annual operating expenses as shown below. Assuming a useful

life of 8 years for each design, no market value, a desired MARR of
10% per year, determine which design should be selected on the
basis of the PW method. Confirm your selection by using the FW and
AW methods.

72
Numerical Problem
An airport needs a modern material handling system for facilitating
access to and from a busy maintenance hangar. A second-hand
system will cost $75,000. A new system with improved technology
can decrease labor hours by 20% compared to the used system.
The new system will cost $150,000 to purchase and install. Both
systems have a useful life of five years. The market value of the used
system is expected to be $20,000 in five years, and the market
value of the new system is anticipated to be $50,000 in five years.
Current maintenance activity will require the used system to be
operated 8 hours per day for 20 days per month. If labor costs $40
per hour and the MARR is 1% per month, which system should be
recommended?

73
 A new highway is to be constructed. Design A calls for a
concrete pavement costing $90 per foot with a 20-year life; two
paved ditches costing $3 per foot each; and three box culverts
every mile, each costing $9,000 and having a 20-year life.
Annual maintenance will cost $1,800 per mile; the culverts
must be cleaned every five years at a cost of $450 each per
mile.

Numerical Design B calls for a bituminous pavement costing $45 per foot
with a 10-year life; two sodded ditches costing $1.50 per foot

Problem each; and three pipe culverts every mile, each costing $2,250
and having a 10-year life. The replacement culverts will cost
$2,400 each. Annual maintenance will cost $2,700 per mile;
the culverts must be cleaned yearly at a cost of $225 each per
mile; and the annual ditch maintenance will cost $1.50 per foot
per ditch.

Compare the two designs on the basis of equivalent worth per

mile for a 20-year period. Find the most economical design on
the basis of AW and PW if the MARR is 6% per year.

74
 Capital : It is a term describing wealth which may
be utilized to economic advantages. Cash, land,
equipment, raw material, finished products,
humans are the forms of such capital

Equity Capital: Common share or equity capital is

Terminologies supplied and used by its owner in the expectation
in Capital that the profit will be earned. There is no
assurance that a profit will, in fact, be gained or
Structure that the invested capital will be recovered.
Debt Capital: It is the borrowed capital. When
borrowed funds are used, a fixed rate of interest
must be paid to the supplier of the capital and the
debt must be repaid at specified time.

75
 Bond: It is essentially a long term note
given to the lender by the borrower,
stipulating the terms of repayment and
other c
Terminologies Debentures: Bond issued without any
in Capital collateral. Thus debenture holders are the
general creditor of the company.
Structure
Preference Share Capital : This capital has
characteristics of both equity capital and
debt capital.

76
 Preference Share Capital:

Two types of dividends are provided to preference share holders.

They are

a. dividends based on fixed percentage ( like debt capital) which is

paid after tax reduction.

Terminologies b. dividends based on earning (like one paid to equity share

holders). So, there is more like a long term debt, and some time
in Capital referred to as hybrid capital.

Structure Like Equity share holders, preference share holders are considered
as owner of the firm, but they do not enjoy any voting rights of equity
shareholders.

In case of preference share capital, dividends are paid after the tax
profit. But, in the case of debt or bond, interests are paid from pre
tax profit. Therefore, preference share are mostly costly.

77
Capital Structure

Capital Structure or financial plan refers to the composition of long term

sources of funds such as debentures, long term debt, preference share
capital and equity share capital including reserve and surplus.

While planning capital structure, one Long Term Debts

needs to decide on the following Bond
aspects: Equity Share

78
 Planning of capital structure should be done
in such a way that long term market price
per share should be maximized and interest
of different groups of people ( promoters,
Basis of creditors, employees, society and
planning capital government) is to be met.
structure Capital structure is said to be appropriate
when the debt capital ratio varies between
45 and 75.

79
Features of a sound Capital Structure

Profitability: Within the constraints, maximum use of leverage at minimum cost should be made.

Solvency : Debt should be added only to the point which does not add substantial risk to the company.

Flexibility: Capital Structure should be flexible enough to meet the dynamic need of company.

Conservation: To some extent, capital structure of a firm should be conservative in the sense that debt
capacity of the company should not be exceeded.

Control: Capital structure should be planned in such a way that the company should always be able to keep
control on it.

80
 1. Leverage effect on earnings per share (EPS) :

The use of fixed cost source of finance such as debt or preference

share capital, to finance the assets of the company is known as
financial leverage or trading on equity.

Determinants Influence on EPS when debt or preference share capital is used

against share capital is leverage effect.
of Capital
Leverage effect is realized mainly due to following reasons:
Structure
a. Cost of debt is usually lower than cost of preference share capital.

b. Interest paid on debt or bond is from pre tax profit while interest
paid on preference share is from tax profit

81
 2. Growth and stability of sales
◦ A firm having stable sales can employ large
amount of debt ( high degree of leverage)
because they will not face difficulty in paying
back the debt

3 Cost of Capital
Determinants ◦ Capital structure of a firm is also shaped by
of Capital the cost of the capital. This means a company
can employ cheaper capital. Usually, debt is a
Structure cheaper source of funds than equity. This is
generally the case when tax are considered.
The tax deductibility of interest changes
further reduces the cost of debt.

82
Determinants of Capital Structure
4. Size of Company
◦ The size of company greatly influences the availability of funds from different sources. A small company finds
great difficulty in raising long term loans. The highly restrictive covenants in loan agreements in case of small
companies make their capital structure very inflexible and management cannot run business without any
interference.

5. Marketability
◦ It means the readiness of investors to purchase a particular type of security in a given period of time.
Marketability does not influence the initial capital structure but is an important consideration to decide the
appropriate timing of security issues

6. Flotation Cost
◦ Flotation cost are incurred only when funds are raised. Generally the cost of debt is less than a cost of floating
an equity issue. This may encourage a company to use debt than issue common shares.

83
Numerical
A firm has total capital of Rs. 10,00,000 which
consists of 3000 ordinary shares @ Rs.100 per
share, Rs. 200,000 preference share at 10 %
interest rate per year and Rs 500000 debts at 12 %
interest per year. If the firm's earning before interest
and tax are Rs. 2,50,000 and tax rate applicable is
30 %, determine earning per share.

84
 A firm has equity capital of 5000 ordinary share @ Rs
100 per share and loan of Rs 10,00,000 borrowed at
an interest rate of 10% per year. The firm wants to
raise Rs 6,00,000 to finance its investment and is
considering two alternative methods of financing I.e

I, To issue 3000 common shares @ Rs 100 each and

to borrow Rs Rs 3,00,000 at 12 % interest.
Numerical ii. To issue 1500 common shares @Rs 100, to issue
2,50,000 preference share at an interest rate of 10 %
and to borrow Rs 2,00,000 at 12 % interest.

If the firm's earning before interest and tax is Rs.

4,00,000 and the tax rate applicable is 30 %,
determine earning per share to decide on the
alternatives.

85