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  • Writer's pictureGermán Villalobos

What you can do to finance your projects

Updated: Oct 27, 2022

By: Germán Villalobos

“So, what do you suggest could be the best way to funding the robots and the other automation equipment?” That was the question the CEO of an intensive labor processes company asked me just after we finished to choose, evaluate, and approve the technical and economic feasibility of a new production system, needed to renewal a production contract from its best and larger customer. This has been a frequent question from many accounts I have developed for more than 30 years in the robotics and automation field, and the answer to that question is what I want to share in my following notes.

This notes about financing Capital Assets are based in the goal of investing in the best technology required to increase sales and revenue or reduce waste and costs, and not as a Risk-based Approach used commonly by corporate controllers’ approach, which is important of course, but we agreed that the big risk is in to lose the best customer which means a large portion of the operation of the company. I mean, this is in finding the best way to fund the investment in Capital Assets from the CEO or CFO approach of capital structure. Let’s start answering that important question.

Sources of funding

The following are the most common sources of money for companies:

  1. Loans: for the lender’s perspective, this are low risk investment because they are usually secured in many forms, receiving their pay back in monthly basis or as contracted.

  2. Bonds: Is also a debt like the loans and receive pay back first, just after loans.

  3. Preferred Stocks: these are stocks that can be considered debt because have priority in receiving their money back

  4. Common Stock: for the stockholder’s perspective, they are in bigger risk than the above due to the last ones to receive their money back, and that is why they get bigger earning as an award of bigger risks.

It is all about risks. The loan holders get paid first in case of any problem, then the bondholders, then the preferred stockholders and finally the common stockholders, the later are who get better return associated to higher risk and therefore are the most expensive from the company point of view. It is also important to say that the common stockholders’ earnings are in function of the company’s earnings, sharing profit and losses.

As said before, preferred stocks look like equity but are structured more like debt, because there is a payment every month that the company must pay, as any debt. In this way, we can see that loans and bonds are less expensive from the company perspective, and with good guarantee, the cost could be even attractively lower.

Capital Structure

The Capital Structure refers to the proportion of debt and equity employed by the firm to fund its operations and finance its assets. The structure is usually expressed as a debt-to-equity ratio.

Debt and equity are used to fund a business operation, capital expenditure, acquisitions, and other investment.

The optimal capital structure of a firm is found when the proportion of debt and equity is in the Lowest Weighted Average Cost of Capital (WACC). To understand and better use of WACC, we have first to estimate the cost of capital. The discount rate used in Discounted Cash Flow (DCF) valuation is based on the cost of capital. Another way to describe the cost of capital is the opportunity cost of making an investment in a business.

To better analyze the information, I will share some cases based on different projects:

Another way to say capital structure is what makes up debt and equity that will maximize the firm value

It is important to say that the riskier or more uncertain the company and the riskier or more uncertain de project the higher the WACC. Therefore, the goal of management is to invest in productive projects with positive returns that maximize shareholders value.

Net Present Value to Evaluate Projects Feasibility

The Discounted Cash Flow (DCF) is a common valuation method used to estimate the value of an investment based on its expected future cash flow, based on the concept of the time value of money. The DCF analysis helps to assess the viability of a project or investment via calculation the present value of an expected future cash flow, using a discount rate, which is the interest rate to determine the present value of future cash flow. Comparing the present value of future cash flow with the actual investment we get the Net present Value (NPV).

It is important to remember on how to grow the company thru increasing the assets side of the balance sheet, investing the money raised by debt and equity in positive NPV projects that will give long term growth of the company. This is with good knowledge and expertise in capital budgeting.

So, wherever you work with an all-equity firm, the WACC is equal to the return of equity (rE). Any project that these companies evaluate must be with discount rate of future cash flow using the return of equity rate, that we have proved it is higher and therefore more expensive for the firm. Using the rE could result in rejecting a project that could be vital for the company’s operation and that could be accepted using a WACC based on the right mixed of debt and equity.

When the company is new and raised money as a start-up, all the liability side of the balance sheet is equity, it means all the investors are exposing its money to high risk but expecting good rewards in return. The new company management, as we already said, use that money in assets to produce income to pay back the initial investment. After some time, the company should find productive investment (NPV+) and raise money at the lower cost as possible to finance new project that generate positive cash flow to grow the company. In the specific case of the company which came up with the question in the beginning of this note, doesn’t even has to look for a productive project, an existing customer is showing a need that the company could satisfy with a productive project that could be NPV+ if is leveraged with the right loan or bond that minimize the WACC.

Let me use an example of a company that found a new productive project that already confirmed is NPV+, for which decided to borrow $20 million of debt at 8% discount rate, but already have a previous debt of $50 million at 7% discount rate. It is important to say that it got attractive rates because the lenders got good guaranties and trust on the company for past success projects. The equity is $60 million and the rE expected for the shareholder is 11%. Let’s find the WACC:

When the company starts new projects, rises money from equity or debt or a mix of both, which uses to purchase assets to make more income from the existing assets and a positive cash flow from the new NPV+ project, as we have said before. So, it is expected that the new project pay back itself with the new cash flow and if possible, helps the general operation to increase efficiency or impulse more sales, in both cases improving the income.

Those new cash flow from new assets go to the debt holder and shareholder fulfilling expected return that could motivate to continue investing in the company for new productive projects, turning in a positive cycle. In difficult economic situations the risk is usually higher, increasing the costs of capital and demotivation for doing investments, but if the project is good, the company has gain trust from the investors and financial institutions, the company could be seen as a good option to locate their money in difficult times.

In conclusion, leveraging a productive project of capital asset that is secured thru a contract with an existing customer, with a good written contract, and with positive NPV, the first option could be debt due to the risk being lower from both perspectives, the company and the lender. One of the management goals is to find the lower WACC that allows evaluating good projects with minimum cost that make them feasible. And, even in bad time, a good company with good projects would continue be attractive for investors.

The above notes are not everything that can be analyzed in this subject, there are much more methods and information that could apply, and for sure you can find out more to use in your projects.

A final comment, when a company leverage good projects thru debt and over time pays down the debt, increases its equity in its balance, the result is a higher Internal Rate Return (IRR) for equity holders.

Download this note in English and Spanish:

20210705 What you can do to finance your projects
Download PDF • 583KB
20210707 Qué puedes hacer para financiar tus proyectos
Download PDF • 562KB

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