This video is an extract from pre-course work on our more challenging courses, and will be included in our Financial Modeling for Business Plans and Financial Modeling for Non-Profits courses.
So before we get started with the financial modeling, it’s important to do a quick review of some basic concepts about equity and debt, just to make sure that we’re all on the same page.
So let’s start with equity. Equity is a form of investment that’s provided by owners who are also called shareholders. In the context of project finance, I might suggest that we divide equity into two different kinds of investors. There’s the project sponsor or the developer, the people who actually create the energy project and will oftentimes invest in it. And then there are more passive investors, institutional investors, or purely financial investors who are not actively involved in the development or day to day operation. Now the profit to the owners or the return on equity is a direct function of how profitable the project is. If the project performs very well, the equity investors do better than if the project does not perform well.
By contrast, debt is a form of investment that’s provided by lenders. What they receive is a set of payments that is fixed according to a schedule of repayment and a specified interest rate. So the profit that the lenders receive does not depend at all on the profitability of the company. If the company does very well, the company does moderately well. Even if the company does badly, the lenders are paid exactly the same thing. Lenders are senior to the owners, so debt is repaid as scheduled before any kind of dividend distributions can be made to the equity investors. And therefore the lenders are facing less risk and they’re also facing less financial reward. Their upside is capped. But if you think about the motivation of a lender, lenders who receive no upside from good performance and only are potentially harm from very bad performance are largely engaged in an exercise of negotiation to try to control their downside risk, oftentimes at the expense of the equity investors upside benefit.
So now let’s talk numerically about how something might look in a project. We would typically describe things in terms of sources of capital and uses of capital. And so in this case, let’s have a very simple use of capital. We’re going to spend $200 million on plant property and equipment to build a renewable energy power plant. And that capital is going to come from two sources. It’s going to come from debt and we’ll fund 140 million of it with debt. Or 70% of the project will be funded with debt and $60 million will be funded with equity or 30%. So over the life of that project, or over the term of a loan, the lenders need to be repaid their principal amount, which is the full 140 million that was borrowed plus interest on that principle. The equity investor must also be repaid its full return of its capital. That initial $60 million of equity that was invested needs to come back and on top of it, the equity investor needs to receive a fair return on its equity and that return on equity is going to be higher than the interest rate that a typical lender would charge in a project.
So why would an investor fund a project with debt? There are two primary reasons. The first is the investor simply doesn’t have enough money to fund the entire project with equity. It’s better to do it with someone else’s money and I may not even be able to come up with enough. The second and really more important one in terms of motivation is that loans are less expensive than equity because lenders are charging an interest rate that’s relatively low when you compare it with the returns that are required and expected by equity investors.
This brings us to an important definition that we’re going to use throughout this course, which is that debt is often referred to as leverage. And if you think about where that comes from, you know a lever is, it’s a simple machine, right? You’ve got a beam balanced on a fulcrum and what does that do? Lever makes it easier to lift a heavy load. And what does debt do? Debt makes it easier for the equity to achieve a higher financial return on an investment because the debt, like a lever is doing the work. So a company or a project investment that has no debt is typically called unlevered or unleveraged and a company or a project that has debt is called levered or leveraged levered projects or projects that have borrowed money are expected to deliver higher returns to the equity investors.
Dan, you use the concept of a lever over a fulcrum for the concept of leverage. That makes sense. However, in many countries around the world, particularly those that speak British English, we use a concept called gearing. It’s really similar. It’s just we’re using gears, mechanical gears to increase our returns to equity. Same concept, different word.
Okay Haydn, you make a fair point. You’re right, American English and British English, they’re not totally the same language and sometimes it can be a bit confusing. I think it’s kind of interesting how both describe debt using a simple machine metaphor. To be honest, I still prefer the simplicity of a lever, but I have nothing against gears, so I will try to be a bit more global in my choice of language for the remainder of this course. Gearing. I’ve just got to learn how to make that sound more natural.