Debt funding of large Investment and Business Projects

Successful commercial activity requires the attraction of funding sources that meet the production and investment needs of the business.

To maintain financial liquidity and business continuity, it is necessary to select the best funding sources that meet certain criteria in terms of cost of capital and time. All investment costs must be covered by the planned cash flows in accordance with the schedule.

Each of the sources of equity financing and debt financing differs in terms of receipt of funds, weighted average cost of capital (WACC) and other criteria. The consequences of using inappropriate funding sources can be serious (for example, a high risk of insolvency or an unfavorable change in the capital structure).

Since external resources are very often used for business development, the most important decision for any company is the right choice of a source of debt funding for investment projects.

Decision-makers must analyze multiple factors and take into account the expert opinion of independent financial advisors.

Havelet Finance Limited offers business debt funding on favorable terms. Our finance team also advises businesses on lending, investment, marketing and more. Read more: https://www.havelet-finance.com/international-loan

Debt or Equity Financing?

Debt funding of large investment projects opens up wide range of opportunities for the construction of capital-intensive facilities in the energy sector, infrastructure and other areas.

The use of debt financing for investment projects is usually considered in situations when a business is on the verge of another expansion, modernization or other project, when there is clearly not enough own funds for the implementation of the project.

The borrowed funds allow the company to pay the initial and operating costs in order to later pay off the debt using the future financial flows provided by the project itself and other activities of the enterprise. Currently, most large companies have access to various sources of funding, including bank loans and equity capital raised through stock exchanges.

Short-term loans are best suited for financing current operations such as purchasing raw materials, supplies, fuel and equipment, paying salaries and paying off other current financial obligations. However, the choice of funding sources for long-term projects is not so obvious.

Debt funding: Merits and Demerits

Basically, debt financing means borrowing funds from banks, other financial institutions or companies in order to support current business activities or implement investment projects. Debt funding takes various forms depending on specific sources and schemes, debt repayment period, collateral, etc.

The Merits of debt funding

Maintaining control over the company is considered to be the most important advantage of this approach. Unlike equity financing, a loan does not imply the transfer of part of the business in the form of shares to the lender.

The Merits of debts funding includes;

•Using the loan for almost any business purpose.
•Reduced tax pressure by treating interest as company expense.
•Minimal interference of creditors in the day-to-day activities of the business.
•Simplified procedures for obtaining funding.
•Flexible terms of debt repayment.

In this case, the ownership remains in the hands of the previous owners, so creditors can neither influence the decisions of the company’s management, nor receive any profit other than the interest and commissions established by the loan agreement. This is fundamentally important for some entrepreneurs who strive to maintain independence above all else.

In particular, corporate control is necessary for companies that are pursuing an aggressive business strategy. For such companies, the loss of some assets in the event of default on obligations may be considered less of a problem than the loss of independence and control. If debt financing of investment projects is carried out with careful planning and professional legal support, the risk of loss of assets for the borrower is minimal.

The second advantage of this type of financing can be tax optimization. Interest payments can be recorded in the balance sheet as expenses of the company, which are not subject to taxation. Consequently, professionally organized and properly executed debt financing can reduce the tax pressure on the borrowing company.

Finally, continuous debt repayment raises the credit rating of the borrowing company, which in the future will greatly simplify the business’s access to debt funding and increase the financial stability of the company as a whole. Thus, with the implementation of subsequent capital-intensive projects, it will be possible to attract loans on more favorable terms with less interest.

Demerits of debt financing

Discussing the negative aspects of this type of financing, a serious demerits is the high cost of borrowed funds. The company is forced to pay not only the principal amount of the loan, but also interest, fees, insurance and other expenses depending on the specific loan agreement. Appearing as debt in the financial statements of the borrower, loans become a serious financial burden for the business for many years and restrict its commercial activities. Constant payments over a long period of time (for large investment projects, the debt repayment period reaches 15 years or more) can pose a threat to business, since market, economic and political changes for such a long period are difficult to predict. Another problem is the complexity of the process of obtaining a large loan.

Obtaining a long-term loan, especially when it comes to large amounts of about 50 million euros or more, is accompanied by a long and complex check of the applicant by the bank. In addition to preparing an application and a set of official documents (including financial statements), borrowers are often required to provide collateral. Real estate (factories, commercial and residential premises, land plots) and movable property (inventories, fuel, equipment, building materials, and so on) can act as collateral. Financial liabilities (loans secured by receivables) also serve as collateral.

In case of default on obligations under the loan agreement, the lender can sell the pledged assets of the debtor and return the loan, including interest.

The possibility of losing part of corporate assets represents another risk for the borrower in the long term. Guaranteed loans can be issued under the official guarantee of government agencies, international institutions, large companies or other reputable partners. Banks use guaranteed loans in cases where the applicant’s solvency is doubtful, and the company is not ready to provide sufficient assets as collateral.

Obtaining large loans to finance investment projects can be extremely difficult for young companies that do not have a good credit rating or a long operating history at all. Highly indebted companies are viewed by potential investors as risky, which limits their funding options.

Sources of Debt Funding for Investment Projects

When embarking on the implementation of the next capital-intensive project, the company will have to choose the most suitable sources of financing. Depending on the origin of funds, the sources of debt funding can be classified into public (state and supranational budgets, charitable foundations) and private.

The last, broadest category includes private investors, banks, financial companies, leasing companies, and so on. In most cases, capital-intensive projects are implemented by large companies that have a complex corporate structure with many distributed divisions and unrelated assets.

These companies have a long and successful operating history and high credit ratings that provide ample opportunities for obtaining bank financing. Usually public and reputable organizations with broad business connections, large companies also have access to financial markets, they very often implement large projects in public-private partnerships (PPPs) and can receive large subsidies. In mature markets, large businesses reap the many benefits of this robust and stable ecosystem, including very low weighted average cost of capital. Large projects usually require long-term debt financing, although corporate needs include working capital loans, debt restructuring or refinancing, equity issues, and so on.

Since each investment project and line of business requires different solutions, large companies often cooperate with 5–6 banks or more, using their financial proposals to the maximum. This is very important to ensure the sustainability of business in the face of political and economic instability.

Debt funding in the context of capital structure

Business financing can be carried out using equity capital and borrowed funds. “Capital” is considered to be the total value of assets contributed to a company from various sources to support its operations. To select the optimal source of funding, a company must balance its Weighted Average Cost of Capital (WACC) and leverage.

The optimal capital structure should provide the lowest weighted average cost of capital. The advantage of large businesses over SMEs is the presence of specialized departments that manage financial operations and maintain an optimal capital structure. Large companies allow themselves to attract highly qualified specialists to provide consultations on project financing. The basis for funding a business, as a rule, is the start-up capital deposited into the company’s account by various investors, which usually include the founders and owners of the company.

When this capital is insufficient to carry out effective commercial activities, companies consider attracting additional sources of financing, that is, debt financing. The cost of equity financing is considered high as investors take a high risk when buying a company’s shares and expect significant dividends. Financing a business solely through equity capital results in a higher WACC. Borrowed funds received by the company from the lender at a fixed interest rate with a specific maturity help to implement large investment projects without the issue of new shares.

Debt funding can be carried out both in the form of a loan and in the form of a bond issue. In both cases, the creditor gets the right to claim back his money on the terms set out in the agreement. Borrowed funds are generally considered more risky than equity financing, but for successful companies with rapid growth and good market prospects, bank lending and bonds are a very attractive

If you need financing for your investment or business project, contact Havelet Finance Limited