Choosing the right corporate finance options requires a deep understanding of their principles, advantages and disadvantages or project finance. With the current wide offer of financial institutions and stock markets, companies can choose the most suitable options for financing planned large investments, depending on the needs of a particular project. Investment decisions, including all aspects related to Corporate finance and project financing, are an important element of business activities and financial management.
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Corporate finance vs Project finance in investment activities
Capital providers, as in project finance, seek to gain control over operations, in particular through clauses that limit the scope of actions taken, the prohibition of certain actions or the obligation of the borrower to perform certain actions. The basis for calculating project parameters will be indicators such as net present value (NPV), internal rate of return (IRR) and debt service coverage ratio (DSCR).
In accordance with the principles of project finance, sponsors do not provide guarantees under SPV (non-recourse financing) or provide limited guarantees (limited recourse financing). This significantly increases the risk for potential lenders and requires an in-depth study of the potential weaknesses of the project before making a decision to participate. Linking an investment project with the rest of the company’s activities has numerous advantages. If necessary, the company can support its project with additional funds generated as part of current activities. However, the risks associated with the overall operation of the company should also be taken into account.
Higher financial costs: Due to the higher risk, banks expect a higher margin on the funds provided (sometimes this financing is 20-30% more expensive than a traditional investment loan). In comparison, the corporate finance formula usually refers to the implementation of an investment project based on an existing business entity with an operating history, adequate assets, and an established funding structure.
The cost of debt financing is usually lower than internal resources, and the risk of the lender is lower than the risk of the owner in case of failure of projects; in addition, there is also a tax shield effect.
The choice of the source of funds determines the cost of capital, and also has irreversible consequences for the subsequent management of the project.
For financing an investment project, the finance team should consider the above.
Main approaches to financing investments
The approach to financing an investment project should be closely related to its specifics. In practice, experts identify such fundamentally different approaches to investment as project finance and corporate finance.
Thanks to globalization, digitalization and the increasing influence of financial markets on the real economy, many important business processes are becoming faster and more complex. At the same time, the influence of various macro-financial, economic, political and market events on all aspects of investment activity is increasing.
Since large investment projects are often worth much more than the value of participating companies, such projects are rarely funded entirely by equity capital. This is where debt financing becomes necessary. Commercial banks play a dominant role as funding sources in this regard. International financial institutions (Inter-American Development Bank, European Bank for Reconstruction and Development) can act as other sources of financing for large projects.
Against this background, the ability to generate realistic forecasts and choose the most appropriate financial instruments is of great importance for the survival of any business, the success of its investment projects and obtaining the necessary funding. Mistakes made during the planning an investment project can lead to critical problems at later stages, which is fraught with financial and reputational losses.
Risks in corporate finance and project finance
Recent studies and international investment practice show that macroeconomic risk has become particularly problematic in recent years (apart from geopolitical risk, which is very difficult to assess).
The risk of correct interpretation of financial forecasts can be explained by the fact that it is almost impossible to develop a reliable assessment of an investment project without drawing up a business plan. At the same time, each business plan must contain financial forecasts in the form of a balance sheet, income statement and cash flow statement for the planned period of financing from external sources.
The general approach to assessing macroeconomic and geopolitical risk in project finance and corporate finance differs little.
Macroeconomic risk is closely related to the inappropriate assessment of financial forecasts.
It refers both to the period before the start of the investment project, and can manifest itself during the commissioning of the facility or during its operation. Even the most conservative approach used at the stage of developing financial forecasts should be based on reliable assumptions about future economic conditions.
New processes in the global economy lead to an increase in project risks, as a result of which it is increasingly difficult for business entities to plan and implement large investment projects.
Project finance is more preferable for sponsors compared to traditional corporate finance mechanisms, despite the lower cost of the latter.
Regardless of the choice of financial instruments, project teams need to be careful when developing forecasts, properly manage risks, and maintain project flexibility in case of changes in the external environment.
If you need professional assistance or financing for your projects, please contact Viola Funding Limited and order a preliminary consultation at any convenient time.
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