11.2: Financing Investment Projects: An Introduction

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 ana lysis 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: \(\text { Assets }=\text { Liabilities }+\text { Owner Equity }\)

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)

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 Blumsack 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 Blumsack 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: \(\text{WACC } = (\text {Fraction financed by debt}) \times (\text {Cost of debt}) \times (1 - \text {Tax Rate}) + (\text {Fraction financed by equity}) \times (\text {Cost of equity})\).

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.