“The primary objective of a company’s capital structure should be to make sure it has enough capital to pursue its strategic objectives and to weather any potential cash flow shortfalls along the way.” (Value:
The Four Cornerstones of Corporate Finance, p. 197)
You are a well-regarded CFO, and you have been asked to prepare a briefing document (a4-page document) for the Board of Directors on your financing techniques and recommend an appropriate capital structure for a major and lucrative power generation project.
The power sector in Southeast Asia has continued to liberalize over the last three decades. While the transmission side is still by and large under the control of State-owned Agencies, the generation side, as well as the distribution side, is now open to private-sector firm participation in various forms (BOOT, BOT, DFBO, etc.), both international and domestic. Your company is developing a hydroelectric power generating plant (100MW) in the northern part of Laos, where the power generated will be sold to neighboring countries. The project cost of the power plant is roughly 100 million (Euro), which is to be financed domestically and internationally by equity, loans, and bond issuance. To prepare for the board meetingyou need todo additional researchas the project is a stand-alone project, and your board members are particularly concerned about exposing the company and its assets to additional and unmitigated risks. In fact, they have heard about and now insist on using an increasingly popular ‘structured project-financing method’ whereby, the company’s assets are not at risk.
Discuss conceptually how might you decide on the mix of debt and equity (leverage ratio), and how might you deal with the various risks (interest rate risk and currency/exchange risk). Finance managers in your Corporate Finance team have suggested that you might consider using swaps to deal with interest rate risk and currency risk. You need to explain to the Board members how they may be useful for the project.
Some of the Board members have limited corporate finance knowledge and it is essential that you make your presentation clear using well-developed chains of logical reasoning. Be sure you explain:
- What is a ‘project financing’ technique as oppose to the ‘conventional financing technique’? When and where might this be appropriate?
- How would you structure your debt financing (loans from banks and financial institutions) with limited or no recourse (limited or no collateral)? What is meant by ‘securitized cash flows’?
- In your view, what amount of ‘skin in the game’ may be necessary?
- Why are interest rate and exchange rate risks a concern for the project?
- How does an exchange rate swap work?