11.1: Overview

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Overview

Steve Jobs and Bill Gates started their respective companies (Apple and Microsoft) in their garages. That makes for a nice story, but how exactly did these companies go from garage-band material to global behemoths? They had to raise money or "capital" somehow - there was only so far that Steve Jobs' own bank account (or his parents' bank account) was going to take him. Eventually both Jobs and Gates needed to seek additional capital from various sorts of investors to help their companies grow - there is, after all, an old saying that it "takes money to make money." True enough; in this lesson, we will take a bit of a closer look at the process of raising capital, from venture capital to stocks to bonds. The world of corporate finance can get very murky very fast; and, in some ways, it's more of a legal practice than a business practice. Our focus is going to be on understanding the various mechanisms that are used to finance energy projects and the implications of those funding mechanisms on overall project costs.

Where we will ultimately wind up is back at this mysterious quantity from Lesson 9 called the "discount rate." Where does that come from? When we are looking at social decisions that involve common costs and benefits, the discount rate is usually more of a matter of debate than anything else. But when a business decision is involved (and that business is a for-profit entity), then there is a rhyme and reason behind the determination of the discount rate as the "opportunity cost" of its investors. There are many different types of investors in a typical firm or project, all of whom face different opportunity costs, so we will encapsulate these in a single number called the "weighted average cost of capital" (WACC). The WACC turns out to be the correct discount rate for a company or a project.

Finally, most of the material that we will develop in this lesson is targeted towards for-profit companies making investments that are expected to earn some sort of positive return over a relevant time horizon. We won't talk much about the non-profit sector except at the very end, when we discuss how the deregulation of commodity markets has changed the investment game for many for-profit firms, but not necessarily for publicly-owned or cooperative firms. If you are interested specifically in project finance concepts for non-profit firms, the Non-profit Finance Fund has some good resources available.

Learning Outcomes

By the end of this lesson, you should be able to:

describe the fundamental difference between debt and equity financing;
identify different types of equity investors;
calculate the cost of debt and equity financing for a single company or project;
using the cost of debt and equity financing, calculate the weighted average cost of capital;
explain how deregulation in energy commodity markets has affected project financing costs.

Additional Readings

We will draw on sections from several readings. In particular, there are a number of good online tutorials on the weighted average cost of capital. If you want to get deeper into this subject, there is no substitute for a good textbook on corporate finance. The all-time classic is Principles of Corporate Finance by Brealy, Myers, and Allen (672 pp., McGraw Hill). This book has gone through a number of editions, so earlier editions are probably available online for relatively little cost.

Below are some freely-available resources on which we will draw:

M.G. Morgan, et al., "The U.S. Electric Power Sector and Climate Change Mitigation," Section II (pp. 20-26)
Business Week, "Debt and Equity Financing" (This is an article that is geared more towards small businesses but has good concise definitions of "debt" and "equity.")
G. Krellenstien, "Transmission Financing" This presentation presents a clear and frank look at the world of financing energy projects.
A primer on "Project Finance" written by HSBC.

What is due for Lesson 11?

This lesson will take us one week to complete. Please refer to the Course Calendar for specific due dates. Specific directions for the assignment below can be found within this lesson.

Homework: Submit a word-processed document with the answer to the Lesson 11 question to the Lesson 11 Drop Box.

Questions?

If you have any questions, please post them to our Questions about EME 801? discussion forum (not email), located in the Start Here! module in Canvas. I will check that discussion forum daily to respond. While you are there, feel free to post your own responses if you, too, are able to help out a classmate.