35 Project Financing

Vishal Kumar

    1. Learning Outcome

 

After completing this module students will be able to:

  1. Understand the concept of Project Financing
  2. Understand various Sources of Finance
  3. Know Long term & Medium term Sources of Finance
  4. Know Short term Sources of Finance

    2. Introduction

 

Finance is the life blood and nerve centre of a business irrespective of its size, kind or nature. Just as circulation of blood is essential in the human body for maintaining life, finance is very essential for smooth running of the business. A project manager has to acquire funds from different sources to meet the financial requirements of business. Adequate finance is necessary for the efficient operation of business. Neither any business can be established nor its development and expansion is possible without adequate finance. On the basis of time, financial requirements of a business can be divided into three parts:

  • Long-term requirements of funds
  • Medium-term requirements of funds and
  • Short-term requirements of funds.

    Long-term requirements of Funds: The requirements of funds for more than five or seven years are called long term requirements of funds. Long term requirements of funds should be met from long term sources. Long term funds are required for the purchase of fixed assets, arrangement of permanent working capital and payment of preliminary expenses. Fixed assets include land, building, plant & machinery, furniture & fitting, patents, goodwill, livestock etc. Fixed assets are used in the business for a long period to earn profits. Preliminary expenses are incurred by the promoters at the time of promotion of company. Similarly working capital is also needed for the business.

 

Medium-term requirements of Funds: Medium term requirement of funds occurs for a period of one to five or seven years. Such funds are required for the projects which are neither of a fixed nature nor of current nature. These funds are needed for the replacement of machinery and equipments or heavy improvements in them, for research and development and heavy expenditure on advertisements etc.

 

Short-term requirements of Funds: Short term funds are needed for a period of less than one year. Short term funds are needed for expenses of routine nature like purchase of goods, payment of salary, wages, rent etc. Therefore, arrangement of adequate working capital has to be made under short term financing. Short term financial requirements should be met from short term sources.

 

3. Sources of Finance: It is worth noting that long term financial requirements should be met from the long term sources, medium term requirements from the medium term sources and short term requirements from the short term sources. Therefore, a project manager must maintain proper balance in the long term, medium term and short term sources of funds. Sometimes, it is difficult to differentiate in the long term and medium term sources. Certain businesses use the funds acquired from the short term sources for the purchase of fixed assets. But it is not considered proper as per the principles of project management because it decreases the liquidity of business and the problem of prompt payment may arise. Similarly, if the funds acquired from the long term sources are used for fulfilling short term requirements, it will be misutilisation of funds as the funds of business will remain unutilized which will reduce profitability. Project manager should also maintain proper balance in owned capital and borrowed capital. If all the requirements of business can be met out of equity capital and reserves and surplus, it will be deprived of the benefits of trading on equity. On the other hand, if all financial needs are met by borrowed capital, there would be fixed burden of interest on business. Therefore, it can be said that, through financial planning, proper balance between owned capital and borrowed capital and among long term, medium term and short term sources should be established.

 

The sources of finance-long term, medium term and short term are different for business. Different sources of finance can be outlined as under:

 

Sources of Long-term Finance: Sources of long term finance can be divided into two parts: i) Owned Capital and ii) Borrowed Capital

 

Owned Capital is provided by the owners of business and includes ordinary shares, preference shares and reserves. On the other hand, Borrowed Capital is raised as long term loan from the borrowers. Main sources of borrowed capital include debentures, bonds, lease financing and long term loans. In India, specialized financial institutions have been established for providing long term loans.

 

Sources of Medium term Loans: Medium term loans can be made available from various sources. Medium term sources include loans from financial institutions, redeemable preference shares, redeemable debentures, public deposits, purchases under Hire Purchase System and accumulated profits.

 

Sources of Short-term Loans: Sources of short term funds include bank loans, public deposits, advances from customers, provision for taxes and credit purchases, commercial papers etc.

 

4. Sources of Long-term & Medium-term Finance

  • Equity Shares: Equity shares have an important place in the capital structure of a company. Ordinary share capital is the base debt and preference share capital. Ordinary shareholders are the actual owners of the company and have full voting rights. They take part in the management of the company through the appointment of directors. They have unlimited interest in the incomes and assets of the company. The main objective of the company is to maximise the value of shares held by shareholders. Ordinary shareholders bear all the risk. There is no predetermined rate of dividend for them. Ordinary shareholders have the right on that income which is left after payment of interest and preference dividend. Similarly, on liquidation, they have the right on those assets which are left after payment of all liabilities and preference share capital. Therefore, following are the main characteristics of equity shares:

    i) Maturity: From the ordinary shares, company gets fixed capital for which the company is not bound to pay during its life time. The shareholders can demand their capital only at the time of liquidation. At the time of liquidation, they will get their capital back only if, there is any balance left after pay-off other liabilities. Company cannot bind its shareholders to sell their holdings.

 

ii) Claims on Income: Equity shareholders of the company are residual owners of income of the company. Their right on income arises only when there is any income left after payment of interest and preference dividend. Even if the company has profits, shareholders can’t force the company to pay dividend to them/. Whole of the profits can be ploughed back for expansion, development and strengthening the financial position of the company. In actual practice, the company pays dividend at a reasonable rate in the event of adequate earnings so that shareholders may have faith in the company. No rate of dividend is fixed. It depends on the policy of the management and quantum of profits.

 

iii) Claims on Assets: Being the residual owners, the ordinary shareholders have last claim on the assets of the company. At the time of liquidation, the assets of company are sold and first of all the claims of creditors and preference shareholders are settled without making any payment to the ordinary shareholders. Whatever the balance is left, ordinary shareholders have full right on it and it is distributed among them in proportion to their holdings. Ordinary share capital provides safety to the interests of creditors.

 

iv) Control: Ordinary shareholders have full right of management and control of the company. Each shareholder has voting right in the meetings of the company in proportion to his holdings in the company. For the operation and control of the company, they appoint directors who act as their representatives. They have right to remove the directors also. If a shareholder can’t present himself in the meetings of the company, he can use proxy.

 

v) Right of Pre-emption: Although the ordinary shareholders can’t force the company to distribute dividend, yet they have been given right to have proportionate interest in the assets, income and control of the company. For this purpose, they have got preferential right to purchase the new shares issued by the company. It is the statutory obligation of the company that it should present new shares to the existing shareholders first. This right of the ordinary shareholders is called right of pre-emption. Each shareholder can exercise this right in proportion to the shares held by him. For example, if a shareholder has 200 shares and company has total issued capital of 2,000 shares, he will have right to purchase 10% of the new shares of the company.

 

  • Preference Shares: Preference share capital is another source of providing long term finance. Preference shares are those shares which have preferential rights regarding the payment of dividend and repayment of capital over the equity shareholders. Equity shareholders can’t be paid any dividend unless dividend at a fixed rate is paid to preference shareholders. In other words, they are paid the dividend out of the earnings after interest and taxes but before any dividend to equity shareholders. Similarly, at the time of liquidation repayment of capital to the preference shareholders is made after settling the claims of creditors and debentures but before making any payment to equity shareholders. Due to these two preferential rights, these shares are called Preference Shares. The main characteristics of preference shares are outlined below:

     i) Maturity: The Company gets fixed capital from the preference shares like the equity shares and it is not bound to repay it. But many times the companies issue redeemable preference shares and fix the time of their redemption under the terms of issue. Such shares are called Redeemable Preference Shares. Redeemable preference shares are redeemed at the option of the company but according to the terms of issue. Sometimes, the companies issue convertible preference shares also. As a result, the preference shareholders have the option to convert their shares in the equity shares of the company. The ratio in which these shares can be converted into equity shares is explained by the articles of the company. The main objective of issuing convertible or redeemable preference shares is to make the capital structure of company more flexible.

 

ii) Claims on Income: Preference shareholders have the preference in relation to dividend over the equity shareholders. They are paid a fixed rate of dividend on the basis of predetermined terms. Equity shareholders can’t be paid any dividend before making any payment to preference shareholders. But it does not mean that it is statutory obligation to pay dividend to the preference shareholders. Even in case of income, they can’t legally compel the company to pay them the dividend. The distribution of dividend depends upon the decision of the Board of Directors. But if the decision for distribution of dividend has been taken, dividend the preference shareholders will have to be paid dividend prior to equity shareholders.

 

Sometimes, the preference shareholders are offered to participate in the additional income of the company, over and above their fixed rate of dividend. Such shares are called Participating Preference Shares. As already said that in case there are inadequate profits or the company suffers losses, it is possible that no dividend is paid on preference shares. But many companies arrange for paying the amount of dividend of such years in the coming years. Such shares are called Cumulative Preference Shares. If at the time of issue of the shares, it is not cleared whether these shares are cumulative or non-cumulative and no provision has been made in the Articles, these shares will be considered as Cumulative Preference Shares. The main objective of the Cumulative Preference Shares is to attract the investors to invest in the company.

 

iii) Claims on Assets: Although assets of the company are not kept as security with the preference shareholders, yet their claims on assets are better to the equity share-holders. At the time of liquidation of the company, the capital of preference shareholders will be paid back to them before making payment to equity shareholders.

  • Ploughing Back of Profits: We have already discussed Equity Shares and Preference Shares as long term sources of finance. Besides, ploughing back of profits is considered as an important internal source of finance. When a company does not distribute whole of its profits and wishes to reinvest a part of if, it is called ploughing back of Profits or retention of earnings. Because ploughing back of profits generates financial sources, it is called self financing or internal financing. Retention of earnings is made in the form of various reserves and funds, such as General Reserve, Dividend Equalization Fund etc. Therefore, every year after payment of tax on the income and distribution of a part of it as dividend, the balance is retained in business. Retained earnings can be used to meet both long term and short term requirements of capital. It is an easy and economical source of finance which can be used for the expansion and modernization of business. These accumulated profits can be used to issue bonus shares. The increase in these accumulated profits increases book value of shares. Besides, a company can follow stable dividend policy due to these accumulated profits and business can save itself from business fluctuations. Debts can be paid easily and the efficiency of company increases. However, retention of profits depends upon the total earnings, dividend policy, tax policy of the government, need for growth, availability of other sources of finance, nature of business of company and the attitude of management etc.
  • Debentures: Debentures are an important source of long term finance for a company. With the help of this source, company arranges for finance for meeting the requirements of development and modernization after its establishment. The funds acquired by issuing debentures are in the form of loans and its holders are the creditors of company.

    In general sense, debenture is a written certificate issued by the company, for the acceptance of the debt, under its seal. The Companies Act, 1956 does not explain clearly the meaning of the term debenture. It only states that “Debenture includes debenture stock, bonds and any other securities of a company, whether constituting a charge on the assets of a company or not”. Section 2 (12), Indian Companies Act, 1956.

 

In debentures, the amount of debt, rate of interest and other conditions are mentioned on the basis of which they have been issued and they have to be redeemed. Here, it is essential to explain the difference between debenture and bond. In America, the term bond is meant to indicate a document which creates charge on the assets of the company. There debentures are ‘meant as unsecured bond which does not create any charge on the assets of the company. At the time of liquidation, debenture holder is treated as general creditor. But in India, there is no difference in debenture and bond. Both are used as synonyms. Recently several financial institutions such as IDBI, IFCI, ICICI and infrastructural companies have issued bonds which are unsecured. But debentures are secured.

 

Characteristics of Debentures

 

i) Maturity: Debentures have a maturity date. Date of maturity means the date of repayment of debentures. As per the terms of issue of debentures, the debentures should be redeemed after a fixed period of time or on a certain date. When the debentures will be redeemed it depends on a number of factors including the condition of capital and money market at the time of issue of debentures, current rate of interest and goodwill of company. Debenture holders do not want that the company may continue to use their funds for a fairly long period. Rather they want the liquidity and security of their money. If there is great risk, the debenture holders will wish an early payment. The debentures can be redeemable as well as irredeemable. The debentures, for the redemption of which, no date is fixed and are redeemed at the option of the company are irredeemable debentures. In India such debentures are not prevalent.

 

ii) Claims of Income: The debenture holders have preferential rights on the income of the company. Firstly, the shareholders can’t be paid any dividend without payment of interest to debenture holders. Secondly, the income from interest on debentures to the debenture holders is fixed and has to be paid essentially, whether the income of company is more or less than it. If company fails to pay them regular interest, the debenture holders can initiate legal action for liquidation of company.

 

iii) Claims on Assets: Debenture holders have preferential claim on the assets of the company also as compared to shareholders. Such situation arises in case of liquidation or reorganization of company. In case of liquidation of the company, the debenture holders get their principal and accrued interest before any payment to the shareholders. Normally, the debenture holders have charge against the special assets so that their interests are secured. Such debentures are called secured debentures.

 

iv) Controlling Power: Debenture holders are the creditors of the company. They do not have any voting rights in the meetings of the company. They cannot participate in the appointment of Board of Directors. But indirectly, they can influence important managerial decisions. For example, they can put a condition to maintain a minimum liquidity ratio or to accumulate fix amount of reserves on the basis of their agreement with the company. But in case the company is paying them interest and principal in time as per contract, they cannot interfere in routine matters of the company.

  • Loans from Financial Institutions: Generally, the companies raise a large portion of their funds by issuing equity shares, preference shares and debentures for the achievement of their objectives including project expansion, modernization, diversification etc. But due to increase in the cost of projects, the industrial units have to depend on medium term and long term loans. For the fulfillment of their requirements for medium term and long term loans a number of financial institutions have been established at the state level, national and international levels. In India, the financial institutions established at the national level include Industrial Development Bank of India (IDBI), Industrial Finance Corporation of India (IFCI), Industrial Credit and Investment Corporation of India (ICICI), Industrial Reconstruction Corporation of India, (IRCI), Life Insurance Corporation of India (LIC), General Insurance Corporation (GIC), Unit trust of India (UTI). Besides, at the state level State Financial Corporations (SFCs) and State Industrial Development Corporation (SIDC) have been established. For example, in Haryana, HFC and HSIDC have been established. All these institutions not only provide long term and medium term loans but also provide technical assistance. Before providing financial assistance, technical, financial and economic aspects of the industrial units are evaluated with the help of experts. The financial institutions provide assistance in the following manner.

    1) To provide long term and medium term loans to the industrial units.

2) To assist in management at the time of their promotion for expansion and development.

3) To provide them technical and financial consultancy at the time of need.

4) To subscribe for the shares and debentures issued by the industrial units.

5) To take part in underwriting shares and debentures issued to the public.

6) To guarantee the loans given by scheduled banks.

7) To provide refinancing facility for the loans given by scheduled banks and co-operative societies to the industrial units.

8) To guarantee the deferred payments.

  • Public Deposits: Public deposits are an important source of medium term and short term finance of a company. In India, this is a traditional source of finance. After the third five year plan, there has been tremendous increase in the public deposits. In India, normally public deposits are accepted for a period of 3 years. From 1-4-87, the maximum rate of interest on public deposits can be 14%. The private sector companies cannot accept a deposit of more than 35% of their paid up capital and free reserves in which share of public can be 25% (maximum) and the balance 10% can be accepted from the shareholders. The public sector companies can get all 35% deposits from the public.

     There are many reasons for attraction of companies towards public deposits. The cost of these deposits is less than the rate of interest offered by banks. There is no need to mortgage the assets for public deposits. Moreover, public deposits are available for a longer period than bank loans. For investors also these deposits can be quite useful because the rate of interest offered on these deposits is higher than the bank rate.

  • Lease Financing: Initially, the concept of lease was limited to land only but for the past few years, lease financing is becoming operational in the industrial arena. Lease is a long term source of business finance. Companies can take necessary business assets on lease rather than buying them. If they purchase these fixed assets, they have to pay in full- Contrarily, under lease agreement company gets the right to use the asset after making part payment for it. Under this arrangement, the owner of the asset (lessor) surrenders the right to use the asset in favour of other person (lessee) in consideration of pre-determined rent. After the lease period, whether the asset will be returned to the lessor or it will be retained by the lessee, depends on the terms of lease. Thus, the ownership and the use of assets, in case of lease, lie in different hands. In industrial era, the use of lease financing started after 1980. During this period, the financial needs of the industrial units also increased due to the rise in price level. Banks and other financial institutions were unable to meet these requirements. Banks were overburdened with the credit to the priority sector. With effect from 1987-88, the Government withdrew the investment allowance. Which made the acquisition of equipments on lease to be more useful rather than purchasing them.

    5.  Short Term Sources of Finance: The short term sources of finance can be divided into two parts.

 

(A)  Banking Sources: The banking sources of short term finance include:

1) Line of Credit: Under this source, bank determines the maximum limit of credit for their customers. Customer can withdraw money from bank within the limit. The maximum amount of credit is determined on the basis of goodwill of customer, his size of business, financial position and allied factors. Interest has to be paid on the amount actually withdrawn.

 

2) Overdraft: In this facility, bank allows the customer to withdraw more amount than his actual deposit in his current account. The excess amount withdrawn is called overdraft. The amount of overdraft is also determined on the basis of financial position of business. The quantum of overdraft is generally less than the line of credit. Bank honours the cheques of customers within a pre-determined time frame. Interest is charged on the actual amount withdrawn.

 

3) Secured Loan: Bank generally grants credit on the basis of security of the current assets like inventory. The assets held as security remain in control of bank. As soon as loan is paid by customer, he is allowed to remove goods from the godown. Under this source, bank grants loan after reserving a fair margin. The amount of loan is transferred to the account of the customer. Interest is charged on the whole amount of loan rather than the actual amount withdrawn.

 

4) Discounting of Bills: Customers can discount the bills due on the future date from the bank. The amount of bill after charging discount is transferred to the account of customer. On the date of maturity, branch collects money from the drawee of the bill.

 

(B) Non-Banking Sources: The non-bank sources of short term finance are:

 

1) Public Deposits: Public deposits for a period of one year are short term source of finance. The public deposits for more than one year are included in medium term sources of finance.

 

2) Short-term Loans: Short term loans, secured or unsecured can be taken from other parties excepting banks including merchant bankers, finance companies, co-operative societies, relatives etc.

 

3) Trade Credit: When the goods are purchased and they are not paid immediately, it acts as short term source of finance. This period of credit is short and after sometime, we have to pay for it. Trader has the benefit of not getting loan from any other source during this period.

 

4) Advances from Customers: The manufactures whose products are in great demand, call for a fixed percentage of the value of order to cash as advance from their customers. Goods are actually delivered after sometime. No interest is paid on this advance.

 

5) Outstanding Liability: Sometimes the expenses of business are not paid immediately. The amount is used in business after delaying the payment of these expenses such as taxes, wages, rent etc.

 

7. Summary: In our present day economy, finance is defined as the provision of money at the time when it is required. Every enterprise, whether big, medium or small, needs finance to carry on its operations and to achieve its targets. In fact, finance is so indispensable today that it is rightly said that it is the life blood of an enterprise. Without adequate finances, no enterprise can possibly accomplish its objectives. Adequate finance is necessary for the efficient operation of business. Neither any business can be established nor its development and expansion is possible without adequate finance. It is required to meet both fixed as well as working capital needs. The various sources of raising long term funds include issue of shares, debentures, ploughing back of profits and loans from financial institutions etc. The short term requirements of funds can be met from commercial banks, trade credit, instalment credit, advances, outstanding expenses etc.

Learn More
Suggested Readings:
  1. Projects: Planning, Analysis, Selection, Implementation & Review, Prasanna Chandra, Tata McGraw-Hill Publishing
  2. Project Management: A Managerial Approach, Jack R. Meredith, Wiley Publications
  3. Project Management: A Development Perspective, Goyal B.B., Deep & Deep Publications.
  4. Project Planning and Control, Mohsin M., Vikas Publishing House.
  5. Project Management, Chaudhary, S., Tata Mc Graw Hill Publications.
  6. Project Management, Maylor, Pearson Education
  7. United Nations Industrial Development Organization, Guide to Practical Project Appraisal–Social Benefit Cost Analysis in Developing Countries, Oxford & IBH.
Points to ponder:
  1. The requirements of funds for more than five or seven years are called long term requirements of funds.
  2. Medium term requirement of funds occurs for a period of one to five or seven years.
  3. Short term funds are needed for a period of less than one year.
  4. Owned Capital is provided by the owners of business and includes ordinary shares, preference shares and reserves.
  5. Borrowed Capital is raised as long term loan from the borrowers. Main sources of borrowed capital include debentures, bonds, lease financing and long term loans.