Factors To Consider When Deciding Upon The Method Of Financing A New Project

Equity and Debt Financing

Question:

Critically discuss the various factors which you would consider in deciding upon the method of financing a new project.

The sustainability in the business is dependent on the investment made in the different projects and the return generated on this investment. One of the most important resources that are required for the businesses is the financing of the businesses. Various options are available for entrepreneurs or the business owners to ensure the availability of adequate capital for the business. It is important to note that the financing of the projects is very critical and scarce resources that require proper planning and coordination. Banks and financial institutions frequently employ different appraisal techniques before sourcing any new project.  Irrespective of the economic conditions the banks are approached for financial requirements. Thus it is very important to ensure the financial viability of the project. The essay discusses the various factors, which need to be considered in deciding upon the method of financing a new project.

Based on the discussion of this factor it may not be a clear difference between the various aspects that have been discussed but it is certainly the basis of ensuring which financing method will be more suitable in comparison to others.

Maintaining suitable capital structure is the important aspect related to financing of the business. The business that have huge potential and optimistic forecast for the business opportunities has more financing opportunities in the form of debt.  In order to ensure to select the suitable financing method various factors need to be considered in deciding upon the method of financing a new project. These have been discussed below

The two broad categories of financing are equity and debt. There are several options, under these categories, that are available for financing. These include venture capitalists, which is a form of equity and borrowing from banks which is debts. The method of financing can be a combination of both. Each type offers certain benefits and also has limitations. The debt from banks results in additional expense for payment of interest on the other hand venture capitalists or any other method of infusion of equity may result in relinquishing control over the asset, operation or business itself. It is important that the balance is maintained between the two so that excessive interest expense does not impact the cash flow which will have an effect on the operations. On the other hand excessive dependency on equity in the form of venture capitalists or Initial Public Offering (IPO) can impact the decision making.

The affordability and control are associated with the employing of debt and equity. In case of debt affordability is impacted whereas the equity financing impacts the control over the business. These are associated with the limitations of equity and debt financing. The equity financing that has been discussed above is related to investors however the affordability might also be there as the investors might not be interested whereas the retained earnings may not be sufficient to fulfill the needs.

Factors to Consider When Deciding Upon the Method of Financing a New Project

Certain industry or business sectors have huge variations in the profitability and the fund requirements. For example certain industries may be capital intensive in the start but generate higher cash in future. Further certain industries may be there which have huge differences in cash flows during different times of operations. In order to maintain the cash flows in such cases which have been discussed above may require huge cash inflows which may be fulfilled by employing debt. Another important factor is the tax rate or subsidies that may be provide. In case of high tax rate and the subsidies debt may be employed. This will reduce the taxes that will be applicable as a result of the interest expense. Last consideration is that the investors have huge expectation from the market but it is expected that the returns will be lower. Such aspects may support the increase in preference of debt rather than employing equity in the business.

The financial goals and the risk tolerance capacity of the firms need to be studied. In case the owners prefer to retain the control and in doing so ensures that the share in the business is not diluted. In such cases, wherein the loans are taken, the personal risk in the business is increased. On the other hand the equity financing ensures that the risk in the business is shared by all the equity holders. Thus in case the risk tolerance of the owners is high, the equity employed will be higher than the debt is employed in the business.

Considering the financial goals of the business, it is closely related to the risk tolerance of the business. The owners’ interest in higher returns would like to have huge operations to be there would employ more capital. In such cases debt may be employed. The businesses where the owners have high risk tolerance will be those that expect higher returns which can be ensured by employing more capital. Such capital needs are funded by the loans from the financial institutions. In case the risk tolerance is lower the financial goals will not be too high and thus the sharing of returns with other equity holders will not be an issue.

The businesses that target high market share may also employ debt to increase the operations and as a result the sales.

The other factors include certain aspects that are specific to the type of financing method, future growth aspects, purpose and role of management. The factors that need to be considered specific to the financing method that are central to the debt financing are the interest rates and the repayment terms. It may be the case that debt is important to be raised in order to fulfill the capital requirements but the industrial conditions and the business or company related conditions increase the risk in the business and as a result of it the interest rates are increased and the repayment terms made a bit stringent. The future growth prospects of the business also influence the financing needs of the business. The future prospects may require the additional funding to sustain in the market.

Financial goals and risk tolerance

The purpose for which the company requires funds also influence the method of financing. In case it is required for investment or the capital expenditure. In such cases the company might consider short term debt options for capital expenditure or long term debt options for investment. In case equity financing is retained earnings may be considered for short term requirement whereas venture capitalist can be considered for long term requirements.

Lastly the role of management is quite important as it highly influences the decision taken by the company on the financing mode. The management that is aggressive is inclined towards debt financing whereas the conservative approach of the management does not prefer debt financing. The aggressive management expects high profitability and low impact of debt on the profitability. In case of conservative approach it is believed that the profitability will be highly impacted and such expenses can be reduced by employing equity.

Conclusion

The complete discussion on the factors that need to be considered while deciding upon the method of financing for the new projects has been conducted.  The above discussion clearly highlights how the source of funds may not impact the capital structure but also impact several aspects such as profitability, control and the returns. The role played by the various factors in the method of financing that is selected is quite interrelated. For example, as discussed above, the businesses where the owners have high risk tolerance will be those that expect higher returns which can be ensured by employing more capital. Such capital needs are funded by the loans from the financial institutions. Both risk tolerance and the financial goals are associated with the role of management. Thus overall the major factor that controls the financing decision is the management viewpoint.

Certainly the other factors such as market conditions, industry conditions and the economic factors do impact the profitability but overall the management decision has the major influence. Government also does play a role and the implication of tax and subsidies does impact the financial decisions to a certain extent.

Lastly the purpose of the funding has been discussed and elaborated wherein it has been mentioned that in case it is required for investment or the capital expenditure both debt and equity can be employed. In such cases the company might consider short term debt options for capital expenditure or long term debt options for investment. In case equity financing is retained earnings may be considered for short term requirement whereas venture capitalist can be considered for long term requirements.

Thus overall the management role is central to the financing decision in case of new projects and the influence of both debt and equity need to be studied. After careful assessment of all the factors that have been discussed above the method of financing for the new projects need to be considered.

References 

Brigham, E. & Ehrhardt, M. (2007). Financial Management: Theory & Practice. Cengage Learning. Business & Economics.

Jacoby, N.H. & Weston, J.F. (1952). Factors Influencing Managerial Decisions in Determining Forms of Business Financing: An Exploratory Study. Conference on Research in Business Finance. Available At: https://www.nber.org/chapters/c4788.pdf.

Brigham, E. & Houston, J. (2015). Fundamentals of Financial Management. Cengage Learning. Business & Economics.