Determining Financial Needs for Projects, Impact of Leveraging on Cost of Finance

Determining Financial Needs for Projects

Add up costs

One-time costs may include such items as legal and professional costs for incorporating or registering your business; starting inventory; licence and permit fees; office supplies and equipment; long-term assets, such as machinery, a vehicle or real estate; consulting services; and website design.

Recurring expenses will include such items as salaries, rent or lease payments, raw materials, marketing costs, office and plant overhead, financing costs, maintenance and professional fees.

Once you’ve determined your initial and follow-on expenses, you will need to estimate how much money you will have at your disposal.

Calculate your financial resources

Estimate how much starting capital you will have and the amount of revenue you’ll be able to generate each month during the start-up period. To calculate the latter, research your potential market and industry averages to come up with realistic numbers.

Now, plug your estimated financial resources and your estimated expenses into a set of financial projections for your business. A quick examination of your projections will show if you’ll have a financial shortfall.

When you have educated yourself on what entails in the market, it’s time to determine what you will be spending on. Starting a business comes with a lot of expenses. Some of these are one- time costs and others may be recurring expenses. Examples of one-time costs include:

• Cost of registering and licensing your business. Getting the appropriate and legal backing is essential for the long-term of the business.
• Cost of Equipment. These are the machinery that will produce a bulk of your services.
• Office supplies
• Vehicle for transportation
• Office/Production Space

On the other hand, recurring expenses will include:

• Maintenance fees that will ensure your machine framework is functioning properly.
• Salaries for your workers. Whether you start with two employees or twenty, you need to have resources to pay them when due.
• Lease payments. If you lose your production space, your business suffers a great deal. It is extremely necessary to do all you can to maintain that space.
• Marketing costs are also recurring expenses. You will need to consistently get your product into the market by advertising through various means. You may use marketers or media.
• Cost of basic materials that you would be using should also be put into consideration.

Project financing: Advantages:

1. Non-Recourse: The typical project financing involves a loan to enable the sponsor to construct a project where the loan is completely ‘non-recourse’ to the sponsor, i.e., the sponsor has no obligation to make payments on the project loan if revenues generated by the project is insufficient to cover the principal and interest payments on the loan. In order to minimize the risks associated with a non-recourse loan, a lender typically will require indirect credit supports in the form of guarantees, warranties and other covenants from the sponsor, its affiliates and third parties involved with the project.
2. Maximise Leverage: In a project financing, the sponsor typically seeks to finance the cost of development and construction of the project on a highly leveraged basis. Frequently, such costs are financed using 80 to 100 percent debt. High leverage in a non-recourse project financing permits a sponsor to put less in funds at risk, permits a sponsor to finance the project without diluting its equity investment in the project and, in certain circumstances, also may permit reductions in the cost of capital by substituting lower-cost, tax-deductible interest for higher-cost, taxable returns on equity.
3. Off-Balance-Sheet Treatment: Depending upon the structure of project financing, the project sponsor may not be required to report any of the project debt on its balance sheet because such debt is non-recourse to the sponsor. Off-balance-sheet treatment can have the added practical benefit of helping the sponsor comply with covenants and restrictions relating to borrowing funds contained in other indentures and credit agreements to which the sponsor is a party.
4. Maximize tax benefit: Project financings should be structured to maximize tax benefits and to assure that all possible tax benefits are used by the sponsor or transferred, to the extent permissible, to another party through a partnership, lease or other vehicle.

Impact of Leveraging on Cost of Finance

Taking on debt, as an individual or a company, will always bring about a heightened level of risk due to the fact that income must be used to pay back the debt even if earnings or cash flows go down. From a company’s perspective, the use of financial leverage can positively or sometimes negatively impact its return on equity as a consequence of the increased level of risk.

Impact on Return on Equity

Return on equity is the rate of return on the shareholders “Equity of a company’s common stock owners. It measures a firm’s efficiency at generating profits from every unit of shareholders’ equity. Return on equity shows how well a company uses investment funds to generate earnings growth. It can be calculated using the following equation:

ROE = Net Income (After Tax) / Shareholder Equity

Leverage, Risk, and Misconceptions

The most obvious risk of leverage is that it multiplies losses. Due to financial leverage’s effect on solvency, a company that borrows too much money might face bankruptcy during a business downturn, while a less-levered company may avoid bankruptcy due to higher liquidity. There is a popular prejudice against leverage rooted in the observation of people who borrow a lot of money for personal consumption, for example, heavy use of credit cards. However, in finance the general practice is to borrow money to buy an asset with a higher return than the interest on the debt. Instead of spending money it doesn’t have, a company actually creates value. On the other hand, when debt is taken on for personal use there is no value being created, i.e., no leveraging.

There is also a misconception that companies enter a higher level of financial leverage out of desperation, referred to as involuntary leverage. While involuntary leverage is certainly not a good thing, it is typically caused by eroding equity value as opposed to the addition of more debt. Therefore, it is typically a symptom of the problem, not the cause.

Combining Operating and Financial Leverage

Operating and financial leverage can be combined into an overall measure called “Total leverage.” Total leverage can be used to measure the total risk of a company and can be defined as the percentage change in stockholder earnings for a given change in sales. In other words, total leverage measures the sensitivity of earnings to changes in the level of a company’s sales.

Methods For Finding Total Leverage

Total leverage can be determined by a couple of different methods. If the percentage change in earnings and the percentage change in sales are both known, a company can simply divide the percentage change in earnings by the percentage change in sales. Earnings can be measured in terms of EBIT, earnings before interest and taxes, or EPS, earnings per share. While EBIT can be determined by referencing a company’s income statement, we can determine earnings per share by dividing the company’s net income by it’s average price of common shares.

TL = {(Revenue – Variable Costs) / Operating income} * Operating Income / Net Income