Posted by Bob on March 02, 19100 at 07:40:55:
If a company has a large independent stand-alone capital investment project with discrete assets, and the project is expected to generate sufficient cash flow to insure the servicing of project debt, then "Project Financing" may be possible. Project financing is often handled by a special division at commercial banks.
Other projects must compete with one another for funding within the limited capital budget of the company. In general, any project with a net present value in excess of the company's cost of capital should be undertaken if budget funds are available.
The valuation of a project should reflect both equity financing and debt financing after taxes. For a levered project, the return on equity (ROE) will be higher than the return on assets (ROA) by a factor equal to the leverage ratio. Both ROE and ROA can be estimated by the internal rate of return (IRR) of the projected cash flow with or without financing, respectively.
Basically, if a strategic project is not attractive without project debt financing, then it should not be undertaken. If a strategic project is attractive without project debt financing, then the method of financing the project is a matter of company cash management.
The criterion to use for project valuation is the net present value (NPV) at the company's hurdle rate, which for a debt-financed project will reflect the additional after-tax cost of interest on project loans. The presentation exhibit can show the project's NPV both without debt financing and with debt financing. Secondary criteria are payout time and the total net cash return/investment ratio.
For a good discussion of this subject, see the book entitled Corporate Financial Analysis : A Comprehensive Guide to Real-World Approaches for Financial Managers, John D. Finnerty, 1986, McGraw-Hill. The book may be out-of-print, but it is the best known source on this topic.
Post a Followup