NATURE OF PROJECT FINANCING

Objectives

At the end of this lecture students should be able to:

1. Define finance and discuss the scope and decision areas in financial management.
2. Discuss the goals of financial management.
3. Explain the shareholder/management (agency) conflicts and possible solutions.
4. Describe the types of Business Organizations
5. Describe Risk and required rate of return.
6. Describe investor’s risk profile.

Introduction

What is finance?

Finance is derived from the Latin word which implies to complete a contract. Hence we can define finance as the application of and optimal utilization of scarce resources. The discipline of finance applies economic principles and concepts in solving business problems.

Financial management: involves raising and allocating funds to the most productive end user so as to achieve the objectives of a business or firm.

The following are the decision areas in finance:

Financing /Capital structure decision

The financial manager needs to understand the firms capital requirements whether short, medium or long term. To this end he will ask himself this question “where will we get the financing to pay for investments?”

The capital structure refers to the mix of long term debt, such as debentures, and equity such as reserves and retained earnings. The financial manager aims at employing the source of funds that will result in the lowest possible cost to the company.

 

/Capital budgeting decision

In capital budgeting the financial manager tries to identify investment opportunities that are worth more (benefits) than they cost to acquire. The essence of capital budgeting is evaluation of investments’ size, risk, and return the funds raised in the financing decision have to be allocated to a viable investment.

 

Working capital management

The term Working capital refers to a firm’s current assets and current liabilities. The financial manager has to ensure that the firm has adequate funds to continue with its operations and meet any day to day obligations. Maintaining an optimal level is therefore important.

 

Distribution decision

This involves the distribution of dividend which is payment of a share of the earnings of the company to ordinary shareholders.

Further details of the above decisions will be discussed later in the text.

 

The goal of the firm from a financial management perspective could be broadly classified in two;

1. Financial goals.
2. Non-financial goals

Financial goals could be either profit maximization goal or wealth maximization.

Non-financial goals include survival, service provision, growth, or the welfare of employees.

 

Financial goals of the firm.

• Profit-Maximization

Microeconomic theory of the firm is founded on profit maximization as the principal decision criterion: markets managers of firms direct their efforts toward areas of attractive profit potential using market prices as their signals. Choices and actions that increase the firm’s profit are undertaken while those that decrease profits are avoided. To maximize profits the firm must maximize output for a given set of scarce resources, or equivalently, minimize the cost of producing a given output.

 

Applying Profit-Maximization Criterion in Financial Management

Financial management is concerned with the efficient use of one economic resource, namely, capital funds. The goal of profit maximization in many cases serves as the basic decision criterion for the financial manager but needs transformation before it can provide the financial manger with an operationally useful guideline. As a benchmark to be aimed at in practice, profit maximization has at least four shortcomings: it does not take account of risk; it does not take account of time value of money; it is ambiguous and sometimes arbitrary in its measurement; and it does not incorporate the impact of non-quantifiable events.

Uncertainty (Risk) The microeconomic theory of the firm assumes away the problem of uncertainty: When, as is normal, future profits are uncertain, the criteria of maximizing profits loses meaning as for it is no longer clear what is to be maximized. When faced with uncertainty (risk), most investors providing capital are risk averse. A good decision criterion must take into consideration such risk.

Timing Another major shortcoming of simple profit maximization criterion is that it does not take into account of the fact that the timing of benefits expected from investments varies widely. Simply aggregating the cash flows over time and picking the alternative with the highest cash flows would be misleading because money has time value. This is the idea that since money can be put to work to earn a return, cash flows in early years of a project’s life are valued more highly than equivalent cash flows in later years. Therefore the profit maximization criterion must be adjusted to account for timing of cash flows and the time value of money.

Subjectivity and ambiguity A third difficulty with profit maximization concerns the subjectivity and ambiguity surrounding the measurement of the profit figure. The accounting profit is a function of many, some subjective, choices of accounting standards and methods with the result that profit figure produced from a given data base could vary widely.

Qualitative information Finally many events relevant to the firms may not be captured by the profit number. Such events include the death of a CEO, political development, and dividend policy changes. The profit figure is simply not responsive to events that affect the value of the investment in the firm. In contrast, the price of the firms share (which measures wealth of the shareholders of the company) will adjust rapidly to incorporate the likely impact of such events long before they are their effects are seen in profits.

• Value Maximization

Because of the reasons stated above, Value-maximization has replaced profit-maximization as the operational goal of the firm. By measuring benefits in terms of cash flows value maximization avoids much of the ambiguity of profits. By discounting cash flows over time using the concepts of compound interest, Value maximization takes account of both risk and the time value of money. By using the market price as a measure of value the value maximization criterion ensures that (in an efficient market) its metric is all encompassing of all relevant information qualitative and quantitative, micro and macro. Let us note here that value maximization is with respect to the interests of the providers of capital, who ultimately are the owners of the firm. – The maximization of owners’ wealth is the principal goal to be aimed at by the financial manager.

 

In many cases the wealth of owners will be represented by the market value of the firm’s shares – that is the reason why maximization of shareholders wealth has become synonymous with maximizing the price of the company’s stock. The market price of a firms stocks represent the judgment of all market participants as to the values of that firm – it takes into account present and expected future profits, the timing, duration and risk of these earnings, the dividend policy of the firm; and other factors that bear on the viability and health of the firm. Management must focus on creating value for shareholders. This requires Management to judge alternative investments, financing and assets management strategies in terms of their effects on shareholders value (share prices).

 

Non-financial goals

• Social Responsibility and Ethics

It has been argued that the unbridled pursuit of shareholders wealth maximization makes companies unscrupulous, anti social, enhances wealth inequalities and harms the environment. The proponents of this position argue that maximizing shareholders wealth should not be pursued without regard to a firm’s corporate social responsibility. The argument goes that the interest of stakeholders other than just shareholders should be taken care of. The other stakeholders include creditors, employees, consumers, communities in which the firm operates and others. The firm will protect the consumer; pay fair wages to employees while maintaining safe working conditions, support education and be sensitive to the environment concerns such as clean air and water. A firm must also conduct itself ethically (high moral standards) in its commercial transactions.

Being socially responsible and ethical cost money and may detract from the pursuit of shareholders wealth maximization. So the question frequently posed is: is ethical behavior and corporate social responsibility inconsistent with shareholder wealth maximization?

In the long run, the firm has no choice but to act in socially responsible ways. It is argued that the corporation’s very survival depend on it being socially responsible. The implementation of a pro-active ethics ad corporate social responsibility (CSR) program is believed to enhance corporate value. Such a program can reduce potential litigation costs, maintain a positive corporate image, build shareholder confidence, and gain the loyalty, commitment and respect of firm’s stakeholders. Such actions conserve firm’s cash flows and reduce perceived risk, thus positively effecting firm share price. It becomes evident that behavior that is ethical and socially responsible helps achieve firm’s goal of owner wealth maximization.

• Growth and expansion.

This is a major objective for small companies which seek to expand operations so as to enjoy economies of scale.

Difficulty of Achieving Shareholders Wealth Maximization

Two difficulties complicate the achievement of the goal of shareholder wealth maximization in modern corporations. These are caused by the agency relationships in a firm and the requirements of corporate social responsibility (As discussed above).

 

AGENCY THEORY.

An agency relationship is created when one party (principal) appoints another party (agent) to act on their (principals) behalf. The principal delegates decision making authority to the agent. In a firm agency relationship exists between;

• Shareholders and management
• Shareholders and creditors
• Shareholders and the government
• Shareholders and auditors

Shareholders and management

The separation of ownership and control in most modern corporations’ causes a conflict of interest between the personal interest of appointed managers (agent) and the interests of the owners of the firms (principals).this conflict is known as the agency conflict.

The following are some decisions by managers which would result in a conflict with shareholders:

1. Managers may use corporate resources for personal use.
2. Managers may award themselves hefty pay rises
3. Managers may organize mergers which are intended for their benefit only and not for the benefit of shareholders.
4. Managers may take holidays and spend huge sums of company money.
5. Managers may use confidential information for their benefit(insider trading)

Resolution of conflict

1. Performance based remuneration

This will involve remunerating managers for actions they take that maximize shareholders wealth. The remuneration scheme should be restructured in order to enhance the harmonization of the interest of shareholders with those of management. Managers could be given bonuses, commissions for superior performance in certain periods.

2. Incurring agency costs

Agency costs refer to costs incurred by shareholders in trying to control management behavior and actions and therefore minimize agency conflicts.

These costs include:

1. Monitoring costs. They arise as a result of mechanisms put in place to ensure interests of shareholders are met. They include cost of hiring external auditors, bonding assurance which is insurance taken out where the firm is compensated if manager commits an infringement, internal control system implementation.
2. Opportunity costs which are incurred either because of the benefit foregone from not investing in a riskier but more profitable investment or in the due to the delay in decision making as procedures have to be followed(hence, a timely decision will not be made)
3. Restructuring costs are those costs incurred in changing or altering an organizations structure so as to prevent undesirable management activities.
4.  Board of directors– a properly constituted board plays the oversight role on management for the shareholders.

 

3. Threat of corporate takeover

When management of a firm under performs this result in the shares of that firm being undervalued there is the threat of a hostile takeover. This threat acts to force managers to perform since should the firm be taken over they will be replaced.

4. Shareholders intervention

The shareholders as owners of the company have a right to vote. Hence, during the company’s AGM the shareholders can unite to form a bloc that will vote as one for or against decisions by managers that hurt the company. This voting power can be exercised even when voting for directors. Shareholders could demand for an independent board of directors.

5. Legal protection

The companies act and bodies such as the capital markets authority have played their role in ensuring trying to minimize the agency conflict. Under the companies act, management and board of directors owe a duty of care to shareholders and as such can face legal liability for their acts of omission or commission that are in conflict with shareholders interests. The capital market authority also has corporate governance guidelines.

6. Use of corporate governance principles which specify the manner in which organizations are controlled and managed. The duties and rights of all stakeholders are outlined.
7. Stock option schemes for managers could be introduced. These entitle a manager to purchase from the company a specified number of common shares at a price below market price over duration. The incentive for managers to look at shareholders interests and not their own is that, if they deliver and the company’s share price appreciates in the stock market then they will make a profit from the sale.
8. Labour market actions such as hiring tried and tested professional managers and firing poor performers could be used. The concept of ‘head hunting’ is fast catching on in Kenya as a way of getting the best professional managers and executives in the market but at a fee of course.

 

 Shareholders vs. creditors

In this relationship the shareholders (agent) are expected to manage the credit funds provided by the creditors (principal). The shareholders manage these funds through management.

Debt providers/creditors are those who provide loan and credit facilities to the firm. They do this after gauging the riskiness of the firm.

The following actions by shareholders through management could lead to a conflict between them and creditors

1. Shareholders could invest in very risky projects

The management under the directive of the shareholders may undertake highly risky investments than those anticipated by the providers of long term debt finance. The creditors would not be interested in highly risky projects because they stand to lose their funds when the investments collapse. Even if the risky projects succeed they would not benefit because they only get a fixed rate of return.

2. The dividend payments to shareholders could be very high

An increase in the dividend rate in most cases is financed by a decrease in investments. This in turn reduces the value of bonds. If the firm is liquidating and it pays a liquidating dividend to its shareholders, the providers of capital could be left with worthless claims.

3. Default on interest payments to bondholders
4. Shareholders could organize mergers which are not beneficial to creditors
5. Shareholders could acquire additional debt that increases the financial risk of the firm
6. Manipulation of financial statements so as to mislead creditors
7. Shareholders could dispose of assets which are security for the credit given
8. Under investments

The shareholders may invest in projects with a negative net present value.

9. The shareholders may adopt an aggressive management of working capital. This may bring conflicts in liquidity position of the firm and would not be in the interest of the debt holders

Resolution of this conflict

1. Restrictive covenants– these are agreements entered into between the firm and the creditors to protect the creditor’s interests.

These covenants may provide restrictions/control over:

1. Asset based covenants- These states that the minimum asset base to be maintained by the firm.
2. Liability based covenant- This limits the firm’s ability to incur more debt.
3. Cashflow based covenant- States minimum working capital to be held by the firm. This may restrict the amount of dividends to be paid in future.
4. Control based covenant – Limits management ability to make various decisions e.g. providers of debt fund may require to be represented in the BOD meetings.

2. Creditors could also offer loans but at above normal interest rates so as to encourage prompt payment
3. Having a callability clause to the effect that a loan could be re-called if the conflict of interest is severe
4. Legal action could also be taken against a company
5. Incurring agency costs such as hiring external auditors
6. Use of corporate governance principles so as to minimize the conflict.

3. Shareholders and the government

The shareholders operate in an environment using the license given by the government. The government expects the shareholders to conduct their business in a manner which is beneficial to the government and the society at large.

The government in this agency relationship is the principal and the company is the agent. The company has to collect and remit the taxes to the government. The government on the other hand creates a conducive investment environment for the company and then shares in the profits of the company in form of taxes. The shareholders may take some actions which may conflict the interest of the government as the principal. These may include;

• The company may involve itself in illegal business activities
• The shareholders may not create a clear picture of the earnings or the profits it generates in order to minimize its tax liability.(tax evasion)
• The business may not response to social responsibility activities initiated by the government
• The company fails to ensure the safety of its employees. It may also produce sub standard products and services that may cause health concerns to their consumers.
• The shareholders may avoid certain types of investment that the government covets.

Solutions to this agency problem

• The government may incur costs associated with statutory audit, it may also order investigations under the company’s act, the government may also issue VAT refund audits and back duty investigation costs to recover taxes evaded in the past.
• The government may insure incentives in the form of capital allowances in some given areas and locations.
• Legislations: the government issues a regulatory framework that governs the operations of the company and provides protection to employees and customers and the society at large.ie laws regarding environmental protection, employee safety and minimum wages and salaries for workers.
• The government encourages the spirit of social responsibility on the activities of the company.
• The government may also lobby for the directorship in the companies that it may have interest in. i.e. directorship in companies such as KPLC, Kenya Re. etc

 

Shareholders and auditors

Auditors are appointed by shareholders to monitor the performance of management.

They are expected to give an opinion as to the true and fair view of the company’s financial position as reflected in the financial statements that managers prepare. The agency conflict arises if auditors collude with management to give an unqualified opinion (claim that the financial statements show a true and fair view of the financial position of the firm) when in fact they should have given a qualified opinion (that the financial statements do not show a true and fair view). The resolution of this conflict could be through legal action, removal from office, use of disciplinary actions provided for by regulatory bodies such as ICPAK.

Types of Business Organizations

The three basic forms of business organizations are a proprietorship, a partnership and a corporation (limited liability companies)

Sole Proprietorship

A proprietorship is an organization in which a single person owns the business, holds title to all the assets and is personally responsible for all liabilities. The main virtue of a proprietorship is that it can be easily established and is subject to minimum government regulation and supervision. The proprietorship’s shortcomings include the owner’s unlimited liability for the all business debts, the limitations in raising capital, and the difficulty in transferring ownership.

The proprietorship pays no separate income taxes.  Rather the income or losses from the proprietorship are included on the owner’s personal tax return.

Partnership

A partnership is similar to a proprietorship, except that it is owned by two or more persons. The profit of the partnership is taxed on the individual partners after sharing.

A potential advantage of a partnership compared to a proprietorship is that a greater amount of capital can be raised.

In a general partnership each partner is personally responsible for the obligations of the business. A formal agreement (partnership deed) is necessary to set forth the privileges and duties of each partner, the distribution of profits, capital contributions, procedures for admitting new partners and modalities of reconstitutions of the partners in the event of death or withdrawal of a partner.

In a limited partnership, limited partners contribute capital and their liability is confined to that amount of capital. There must be however, at least one general partner in the partnership who manages the firm and his liability is unlimited.

Types of partners

1. General partners- they have an unlimited liability and take active participation the running of the business.
2. Limited partners- they have a limited liability and do not take part in the management of the partnerships.
3. Sleeping partners- they have no active role, but they contribute in the capital of the business and will participate in the profits although at a lower proportion.

Joint stock company/ Corporation

Joint stock companies/Corporation A corporation is an “artificial entity” created by law. A corporation is empowered to own assets, to incur liabilities, engage in certain specified activities, and to sue and be sued. The principal features of this form of business organization are that the owner’s liability is limited; there is ease of transfer of ownership through sale of shares; the corporation has unlimited life apart from its owners and; the corporation has the ability to raise large amounts of capital.

A possible disadvantage is that corporation profits are subject to double taxation. A minor disadvantage is the difficulties and expenses encountered in the formation. Corporation are owned by shareholders whose ownership is evidenced by ordinary stocks shareholders expect earn a return by receiving a dividend or gain decisions.

Corporations are formed under the provisions of the Companies Act (CAP486). A Board of Directors, elected by the owners, has ultimate authority in guiding the corporate affairs and in making strategic policy decisions. The directors appoint the executive officers (often referred to as management) of the company, who run the company on a day-to-day basis and implement the policies established by the directors. The chief executive officer (CEO) is responsible for managing day-to-day operations and carrying out the policies established by the board. The CEO is required to report periodically to the firm’s directors.