If you are a student of finance or simply curious about what these terms mean, you’re at the right place. We will discuss these topics in lucid terms so that you can have a basic understanding about how these two kinds of finance work in real settings.
To be honest, corporate finance and project finance are subjects you should read for at least 100 hours or more if you want to understand the intricacies. But, in this article, we will discuss the overview with few examples so that before you start studying and go into detail, you have some idea about what you’re trying to go through.
That doesn’t mean we will cover just the chicken-feed. Nope. We will give enough material for you to ponder so that you get more interested in these subjects. Sounds good? Let’s get started.
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Why study corporate finance & project finance?
The basic reason for which you should study these two subjects is because you need to understand how these two are different from each other. Corporate finance is way different than project finance. For many students of finance who will join the organization after their graduation or post-graduation may face the difficulty to analyse these two in greater detail. For example, if you complete your MBA in Finance and join an organization as Sr. Financial Executive and the organization is mainly a matrix organization that goes their way up through large projects, how would you handle it? You need to know project finance in depth.
On the other hand, if you work for an organization which maintains a flat structure and thrives on maintaining proper debt-equity ratio, you need to know how you would be able to finance your operation and make your presence count. Corporate finance will help you in that.
Moreover, both of these subjects will teach you to understand the process of sourcing the money from the financial institutions or banks, the details of the documents, the parties involved in the process and more. We will discuss it further in the next sections. Hang tight. The muddle will get settled as you read on. And these terms will make perfect sense.
Conceptual Differences – Corporate Finance vs Project Finance
What is corporate finance?
In organization where corporate finance is practiced, the objective of practicing it is to maximise the wealth of the shareholders. Corporate finance mainly deals with the sources of funds and how the optimum capital structure will be achieved.
Let’s take an example to understand that.
ABC Ltd. loans 50% of funds from creditors with an assurance to give back 15% within 5 years. And the rest of the amount they source from their equity shareholders. Let’s say they pay dividend and the dividend cost is 10% on the profit. At the end of the day, these 15% and 10% are their cost of capital which they want to reduce by any means. So they need to find out a proper debt-equity ratio (now it is 50:50) which will reduce their cost of capital. At the same time, if they can reduce their total cost of capital (debt and equity included), they will be able to keep better profits or they can think of re-investing the profit into the business. Corporate finance will help ABC Ltd. to figure out these things and helps them find an optimum solution.
Now, you can understand why corporate finance is so very important. The above description is just an example and there are many avenues of corporate finance which we will talk about in later sections.
What is project finance?
It is useful in cases where the finance is required in case of a large industrial or renewable energy project. Project finance is used to finance the project in sequential process. The whole amount is not invested upfront.
In project finance, financial institutions can’t see your balance sheet upfront in case of a project. They finance the project on the basis of the projected cash flow. If the cash flow seems satisfactory and beneficial to the financial institutions they invest in the project.
For example, if X project is needed to be started, they contact a bank or a financial institution and ask for 10% of the money required for the project by showing the projected cash flow for future. Now, it’s the complete discretion of the bank or financial institution to decide whether to invest in that project or not. Usually, there are number of equity investors who invest in the project as sponsors and typically these loans are non-recourse loans (secured loan) which are given against project property. The loans are paid completely from the project cash flow and if the parties default to pay back the loan, then the project properties are being seized. To do the whole process properly, a special purpose entity is created for the entire project. This is how project finance works.
There are many concepts in corporate finance which will help you understand the whole process. We will look at most common and mostly used terms so that you can have an idea about them.
- Capital Structure: To understand corporate finance, you need to know capital structure well. A firm which runs its operation on day to day basis (not project wise) needs to find source of funds. The source of funds can comprise of their own capital funding or sourcing the money from IPO or taking loan from creditors around in the market. Capital structure is how a firm finances its operations and growth by sourcing the money from different avenues.
- Dividend Policy: Many firms source their major funds from equity shareholders. Equity shareholders buy shares from the firm and invest their money in the firm. They are called the owners as they are only paid if the company makes profits. Otherwise they won’t be paid anything. Now, the dividend policies for firms are often different. Some give cash dividends to equity shareholders and some keep the entire profit for re-investment. There’s an argument with the dividend relevancy and irrelevancy on the market price of share. Taking into account all these things, a firm decides upon its dividend policy.
- Working Capital Management: In simple terms, the firm needs money to run the operation. The money for day-to-day operation is called working capital. In different terms, working capital is the difference between current assets and current liabilities on any given day. If current assets are more than current liabilities, then the working capital is positive. If current assets are less than current liabilities, then the working capital is negative. The working capital management is not thought upon in the way long term capital is being perceived. There are few things to consider while thinking about working capital management – first of all, cash flow is most important in case of working capital management, it’s also termed as liquidity; another thing which firm needs to consider is profitability or return on capital.
There are many things to consider in project finance. In this section, we will learn about few important concepts and the parties involved in the process.
Project development is an important concept in project finance. As the financing is done on the sequential progress of the project, understanding project development is important. There are three stages in project development –
- Pre-bid stage
- Contract negotiation stage
- Money-raising stage
There are many parties involved in project finance. Let’s look at all these parties in brief –
- Sponsors: People who sponsor the project.
- Lender: Financial institutions which lend money for project.
- Financial advisors: They help the parties to understand how much return on investment they can make. They can be in both sides – lenders or borrowers.
- Technical advisors: Often for effective execution of the project, technical consultants are hired. They act as technical advisors for the project.
- Legal advisors: As the name suggests, they help in legal matters.
- Debt Financier: People who give secured loan for the project on the basis of project assets.
- Equity Investors: People who invest the money in lieu of shares.
- Regulatory agencies: Generally, government authorities who take care of the regulations in regard to the project intricacies.
- Multilateral agencies: The agencies are part of the World Bank group.
The sponsor who will invest in the project needs to know how the project will do. Thus they take help of an expert to do the financial modelling to understand how the project may go in future. He will also get an idea how much projected cash-flow he can expect. On the basis of that, he will decide to invest. Actually, financial model is a spread-sheet which is being used for calculating financial model.
There are few documents which are of utter importance. Let’s have a look at them –
- Shareholder/sponsor documents
- Finance documents
- Project documents
- Other project documents
There are many more things which are important in project finance. The above are the most important things to consider.
Corporate finance vs Project finance
We have discussed few things about both of these subjects. Now, let’s look at them to see how they are different from each other.
|Points of difference||Corporate Finance||Project Finance|
|Stage||In the early stage of the company, corporate finance is being introduced. When an organization is just starting up, corporate finance is what suits the company to finance through.||In case of companies which run projects usually seek the help of project financier when they are 3 years or little less in the operation. At this moment they need expansion.|
|Proof of concept||In case of corporate finance, in the first stage of company, financier looks for “commercial proof of concept” and that is revenue.||In case of project finance, they look for the projected cash flow as usual.|
|Risk||As the company is starting out, the risk of the investor is much higher than normal.||Usually, the risk is much lower.|
|Returns||As the risk is higher, the returns (ROI) are usually higher. But some investors accept lower returns thinking about the impact on society and environments (if any).||As the risk is lower and the payment is given from the cash flow (principal plus interest), the returns are usually lesser.|
|Collateral||The financier usually gives the loan on the assets of the company.||The financier looks at the project assets as collateral.|
|Decisional basis||The investors look at the balance sheet of the company before they invest.||The financiers look at the projected cash flow by following the route of financial modelling.|
|How equity is defined||Equity is the ownership of the company with several benefits. First of all, there would be voting rights and then management may classify equity ownership (common vs. preferred).||Equity comprises of various direct investments including mezzanine debt, grant, cash or other forms of funds.|
Career opportunities – Corporate Finance vs Project Finance
There are many opportunities in corporate finance. The key opportunities will lie in two main areas – accounting and finance and that would be your key functions as well. You will be able to work as investment banker, financial analyst among other finance roles.
In project finance as well, there are many opportunities. But you need to understand the process well, before you go on chasing your dream. You can be on the either side. Either you can work as a financier for a bank or you can arrange the finance for the project.
What to Choose?
From the above discussion, it’s clear that corporate finance and project finance are completely different concepts and they are being utilized by the companies at different points of time in their growth chart.
The thing that will give you huge boost is to understand both of them well. If you want to be a top-rated financial professional, it would be prudent for you to get some experience in each of them. Then if you want you can start you own finance consulting firms where you would be helping both parties (lenders and borrowers) to get the desired results. Both of these are exciting in terms of career opportunities. All you need to do is to have practical experience to get a hang of them.