Financing Investment Projects: An Introduction
A lot of what we will be studying in this lesson falls under the umbrella of "corporate finance," even though our focus is actually individual energy projects, not necessarily the companies that undertake those projects. Still, there are a number of parallels and many concepts of how companies should finance their various activities are immediately relevant to the analysis of individual projects. After all, like companies as a whole, individual projects have capital, staffing, and other costs that need to be met somehow. And a company can sometimes be viewed as simply a portfolio of project activities. Similarly, an individual project can be viewed as being equivalent to a company with one single activity. (Following deregulation in the 1990s, a number of major energy projects, such as power plants, were actually set up as individual corporate entities under a larger "holding company.") A lot of the emphasis in the corporate finance field is how companies should finance their various activities. (For example, in the readings and external references, you will see a lot of mention of "target" financial structures.) That isn't really our focus - we are more concerned with understanding the various options that might be available to finance project activities. The "right" financing portfolio is ultimately up to the individuals or companies making those project investment decisions.
Project financing options are numerous and sometimes labyrinthine. You may not be surprised that lawyers play an active and necessary role (sometimes the most active role) in structuring financial portfolios for a project or even an entire company. While individual finance instruments span the range of complexities, the basics are not that difficult. For an overview, let's go back to the fundamental accounting identity:
The balance sheet for any company or individual project must obey this simple equation. So, if an individual or company wants to undertake an investment project (i.e., to increase the assets in its portfolio), then it needs some way to pay for these assets. Remembering the fundamental accounting identity, if Assets increase, then some combination of Liabilities and Owner Equity must increase by the same dollar amount. Herein lies the fundamental tenet of all corporate and project finance: financing activities that increase the magnitude of Assets must be undertaken through the encumbrance of more debt (which increases total Liabilities) or through the engagement of project partners with an ownership stake (which increases total Owner Equity).
Hence, all projects must be financed through some combination of "debt" (basically long-term loans by parties with no direct stake in the project other than the desire to be paid back) and "equity" (infusions of capital in exchange for an ownership stake or share in the project's revenues).
The following video introduces debt and equity in a little more detail. The article from Business Week , while it goes more into the specifics for small businesses than our purposes require, also has a nice overview of debt and equity concepts.
Video: Debt and Equity Financing (4:51)
MATT ALANIS: Welcome to Alanis Business Academy. I'm Matt Alanis. And this is an introduction to debt and equity financing.
Finance is the function responsible for identifying the firm's best sources of funding, as well as how to best use those funds. These funds allow firms to meet payroll obligations, repay long-term loans, pay taxes, and purchase equipment, among other things. Although many different methods of financing exist, we classify them under two categories, debt financing and equity financing.
To address why firms have two main sources of funding, we have to take a look at the accounting equation. The accounting equation states that assets equal liabilities plus owner's equity. This equation remains constant, because firms look to debt, also known as liabilities, or investor money, also known as owner's equity, to run operation.
Now let's discuss some of the characteristics of debt financing. Debt financing is long-term borrowing provided by non-owners, meaning individuals or other firms that do not have an ownership stake in the company. Debt financing commonly takes the form of taking out loans and selling corporate bonds. For more information on bonds, select the link above to access the video "How Bonds Work." Using debt financing provides several benefits to firms. First, interest payments are tax deductible. Just like the interest on a mortgage loan is tax-deductible for homeowners, firms can reduce their taxable income if they pay interest on loans. Although the deduction doesn't entirely offset the interest payments, it at least lessens the financial impact of raising money through debt financing. Another benefit to debt financing is that firms utilizing this form of financing are not required to publicly disclose of their plans as a condition of funding. This allows firms to maintain some degree of secrecy so that competitors are not made aware of their future plans. The last benefit of debt financing that we'll discuss is that it avoids what is referred to as the dilution of ownership. We'll talk more about the dilution of ownership when we discuss equity financing.
Although debt financing certainly has its advantages, like all things, there are some negative sides to raising money through debt financing. The first disadvantage is that a firm that uses debt financing is committing to make fixed payments, which include interest. This decreases a firm's cash flow. Firms that rely heavily on debt financing can run into cash flow problems that can jeopardize their financial stability. The next disadvantage to debt financing is that loans may come with certain restrictions. These restrictions can include things like collateral, which require a firm to pledge an asset against the loan. If the firm defaults on payments, then the issuer can seize the asset and sell it to recover their investment. Another restriction is what's known as a covenant. Covenants are stipulations, or terms, placed on the loan that the firm must adhere to as a condition of the loan. Covenants can include restrictions on additional funding, as well as restrictions on paying dividends.
Now that we've reviewed the different characteristics of debt financing, let's discuss equity financing. Equity financing involves acquiring funds from owners, who are also known as shareholders. Equity financing commonly involves the issuance of common stock in public and secondary offerings or the use of retained earnings. For information on common stock, select the link above to access the video "Common and Preferred Stock." A benefit of using equity financing is the flexibility that it provides over debt finance. Equity financing does not come with the same collateral and covenants that can be imposed with debt financing. Another benefit to equity financing is that it does not increase a firm's risk of default like debt financing does. A firm that utilizes equity financing does not pay interest. And although many firms pay dividends to their investors, they are under no obligation to do so.
The downside to equity financing is that it produces no tax benefits and dilutes the ownership of existing shareholders. Dilution of ownership means that existing shareholders' percentage of ownership decreases as the firm decides to issue additional shares. For example, let's say that you own 50 shares of ABC Company. And there are 200 shares outstanding. This means that you hold a 25% stake in ABC Company. With such a large percentage of ownership, you certainly have the power to affect decision making. In order to raise additional funding, ABC Company decides to issue 200 additional shares. You still hold the same 50 shares in the company. But now there are 400 shares outstanding, which means you now hold a 12 and 1/2% stake in the company. Thus, your ownership has been diluted due to the issuance of additional shares. A prime example of the dilution of ownership occurred in the mid-2000s when Facebook co-founder Eduardo Saverin had his ownership stake reduced by the issuance of additional shares.
This has been an introduction to debt and equity financing. For access to additional videos on finance, be sure to subscribe to Alanis Business Academy. And also remember to Like and Share this video with your friends. Thanks for watching.
Debt and equity each have costs. The cost of debt is pretty explicit - lenders typically charge interest. The cost of equity is a little more complex since it represents an "opportunity cost." If an equity investor (like a potential holder of stock) buys into Acme PowerGen Amalgamated, that investor is foregoing the returns that it could have earned from some other investment vehicle. The attitude of most investors, in the immortal words of Frank Zappa, is "we're only in it for the money." Those foregone returns represent the opportunity cost of investing in Acme PowerGen Amalgamated. If we weight these costs by the proportion of some project that is financed through debt and equity means, we have a number that is known as the "weighted average cost of capital" or WACC. The general equation for WACC is:
Here, the "costs" are generally in terms of interest rates or rates of return. So, a company facing a 5% annual interest rate would have a "cost of debt" equal to 5% or 0.05. We'll get into these pieces in more depth, and will explain the strange tax term in the WACC equation after we gain more of an understanding of debt and equity, and how the costs of debt and equity might be determined.