Project Finanace
Project finance is not as well understood than it should be due largely to the fact that there is no consensus definition of project finance. Perceptions of what constitutes project financing vary depending on the definition of project finance you first learned. We list three of the most widely accepted definitions below.
- A financing of a particular economic unit in which a lender is satisfied to look initially to the cash flow and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan.
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The raising of funds to finance an economically separable capital investment project in which the providers of the funds look primarily to the cash flow from the project as the source of funds to service their loans and provide the return of and a return on their equity invested in the project.
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The financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash flow generated by the project.
Equity Financing vs. Debt Financing: An Overview
To raise capital for business needs, companies primarily have two types of financing as an option: equity financing and debt financing. Most companies use a combination of debt and equity financing, but there are some distinct advantages to both. Principal among them is that equity financing carries no repayment obligation and provides extra working capital that can be used to grow a business. Debt financing on the other hand does not require giving up a portion of ownership.
Companies usually have a choice as to whether to seek debt or equity financing. The choice often depends upon which source of funding is most easily accessible for the company, its cash flow, and how important maintaining control of the company is to its principal owners. The deb-to-equity ratio shows how much of a company’s financing is proportionately provided by debt and equity.
Key Takeaways
There are two types of financing available to a company when it needs to raise capital: equity financing and debt financing.
Debt financing involves the borrowing of money whereas equity financing involves selling a portion of equity in the company. The main advantage of equity financing is that there is no obligation to repay the money acquired through it.
Equity financing places no additional financial burden on the company, however, the downside can be quite large.
The main advantage of debt financing is that a business owner does not give up any control of the business as they do with equity financing.
In fact, the downside is quite large. In order to gain funding, you will have to give the investor a percentage of your company. You will have to share your profits and consult with your new partners any time you make decisions affecting the company. The only way to remove investors is to buy them out, but that will likely be more expensive than the money they originally gave you.
Debt Financing
Debt financing involves the borrowing of money and paying it back with interest. The most common form of debt financing is a loan. Debt financing sometimes comes with restrictions on the company’s activities that may prevent it from taking advantage of opportunities outside the realm of its core business. Creditors look favorably upon a relatively low debt-to-equity ratio, which benefits the company if it needs to access additional debt financing in the future.
The advantages of debt financing are numerous. First, the lender has no control over your business. Once you pay the loan back, your relationship with the financier ends. Next, the interest you pay is tax-deductible. Finally, it is easy to forecast expenses because loan payments do not fluctuate.
The downside to debt financing is very real to anybody who has debt. Debt is a bet on your future ability to pay back the loan.
What if your company hits hard times or the economy, once again, experiences a meltdown? What if your business does not grow as fast or as well as you expected? Debt is an expense and you have to pay expenses on a regular schedule. This could put a damper on your company’s ability to grow.