Module 12: Financing (investments)

12.5. What are the key issues?

...Cost of capital
...Rate of returns
...Capital and operational costs
...Borrowing requirements
...Finance structuring
...Municipal finances and budgets
...Asset management and valuation

Cost of capital

Cost of capital is designed to give an idea of the costs associated with the different financing options – debt and equity.

It is rather easy to find out the cost of debt, as it carries an explicit interest rate paid to the lender. The cost of equity is the cost to be paid to attract investors to invest in the stock of a company and to keep them interested in retaining their investment. Weighted average cost of capital is the average of the cost of each of these sources of financing weighted by their respective usage in the given situation.

There are numerous formulas to determine company's financial performance. Two general formulas are used to determine the value of an investment:

Investment = Fixed Assets + Working Capital

Cost of Capital = [(Repayment - Investment) x 100] / Investment

These two formulas can be used to calculate the optimum debt to equity ration necessary to finance further growth or acquisition.

Equity capital is more costly than debt because it requires higher premiums for risk and interest on debt is tax deductible while dividends and equity capital are not. However, although debt is generally cheaper than equity, a long-term equity stake by the sponsor (which is sometimes also the operator) ensures that management has a long-term interest in the project and that cash flow growth leads to capital appreciation. Equity also reduces the debt service burden on the cash flow, which can be especially important in a project’s early development phase.

In full concessions and privately owned utility companies internal cash generation can provide an important source of equity for financing investment.
Besides the cost of capital per se the cost of private investment includes:

◊ Government taxes and duties: customs duties, equipment insurance, vehicle and company registration, corporate income and property tax;

◊ Transaction costs – costs of putting partnership together, from tender through negotiation of the partnership framework;

◊ Informal costs associated with bureaucratic structures and political manipulation.

Rate of returns

Rate of Return on Invested capital (ROI) is the measure of the assess value, and is expressed as a percentage ratio:

ROI =Profit x 100 / Investment

Often an investor has, as one of their investment criteria, a minimum acceptable rate of return on an acquisition. The rate of return should cover the cost of debt and equity financing, or, the weighted average cost of capital (WACC) of the project.

Inflation, taxes, depreciation, and international currency fluctuations may also need to be considered. One method is to calculate both Internal Rates of Return (IRR) and Net Present Value (NPV) using various cash flows and discount rates to determine the true value of investment.

Investment project can be recognized as applicable if one of the following conditions is reached:

NPV>0
IRR > E ( E-Interest rate)

Capital and operational costs

Capital costs
include the costs of building assets used for service and products production and in some cases costs for buildings and grounds. The capital costs in a tariff formula are comprised of the return on and of these capital expenditures.

Operational costs
often called operating and maintenance (O&M) expenses, are the costs of operating the business and performing routine maintenance of the assets in order to produce and distribute services.

Borrowing requirements

The measurement of Borrowing Requirements intends to provide the information about the financial results of the activities carried out by the company in order to comply with its functions, in a summarized and timely fashion.

These indicators are the result of an effort to collect and regroup information, most of which is already known by the public, but that in the past was published separately or in aggregated manner.

Borrowing requirements by governments are met, in large part by funds raised on financial markets. Debt management techniques and policies can influence substantially the functioning of capital markets and the development of new financial instruments. As a consequence of globalisation, cross-border government borrowings have become more significant. Government debt instruments attract both institutional and retail investors and have an important share in the portfolios of fund managers.

Finance structuring (financing and tariffs)

Financial structuring need to be developed for each project. It should involve a mix of financing sources, secured by revenue stream. In structuring the finances there is a need to have the correct structure in respect to:

1. Mix of debt to equity.
This is an important mix and one that if it is out of balance means excessive risk or under realisation of the potential of the business.

2. Maximisation of internal funding.
This is the cheapest form of finance to a business and is internally generated by cash flow optimisation and the correct management of working capital.

3. Sources of finance.
This depends on numerous features such as the type of industry, the stage of growth, the funding needs etc. There is a risk in obtaining funding from numerous sources equally as much as there is a risk in being too limited in your financiers. However, building a solid relationship with the financiers is important.

4. The types of financing instrument.
Examples of these are leases, short term facilities, long term funding, perpetual debt, etc.

5. Terms of finance.
The terms of the finance include the period of finance, the repayment programme, the interest rate, the costs in establishing and obtaining the finance, the covenants and restrictions placed by the lender on the business, the required level of security and the information flow that is required by the financiers. All of these areas need to be considered.

6. Planning for the future business and funding needs is an extremely important issue.
You are not borrowing for today's events, you are borrowing for the future and in this regard, planning is essential.

7. Management control over the business.
It is important that management reporting and control procedures are in place to ensure that the financing is optimised.
Because finance structuring is a complicated procedure, it is strongly advised to engage professional consultants.

Municipal finances and budgets

A budget is a financial plan, which summarises, in financial figures, the activities planned for the forthcoming year by setting out the costs [expenses] of these activities, and where the income will come from to pay for the expenses.

There are two types of budgets: operating budget and capital budget.

Capital budget deals with big costs that you pay once to develop something, and how you will pay for this – for example putting in water pipes to a new township.

Operating budget deals with the day-to-day costs and income to deliver municipal services – for example the meter readers’ wages and maintenance work to keep the water flowing.

Municipalities must ensure that there will be adequate money to pay for their planned expenditure if they are to "balance the budget". There are various sources of income that can be used by municipalities to finance their expenditure, which could be divided on capital and operations budget financing:

a. Main sources of capital budget financing
• External loans
• Internal loans
• Contributions from revenue
• Grants
• Donations and public contributions

b. Main sources of operational budget financing
• Service Charges / Tariffs
• Equitable share - an amount of money that a municipality gets from national government each year.

Asset management and valuation

Asset / liability management – the task of managing the funds of a financial institution to accomplish the two goals of a financial institution:

1. to earn an adequate return on funds invested; and

2. to maintain a comfortable surplus of assets beyond liabilities.

Asset management encompasses a wide range of management decisions, such as capacity allocation, asset purchase/lease decisions and pricing. In high-fixed-cost businesses such as manufacturing and most types of service provision, asset management is often one of the most powerful levers in determining relative profitability.

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