How are projects paid for? Generally by financing the project. The funds that pay for the project may come from operations (for example, from revenues) or from capital expenditure. Capital expenditures are typically made from the company treasury or reserves. As a third method, the organization wanting to perform a project can borrow, and then repay, money. There are a variety of ways to do this borrowing.
Unsecured or limited recourse financing is by funds made available and secured only by the assets in use by the project and any future revenue stream the project may produce. The borrower does not have to offer up other assets or cash as collateral. This is what is referred to as project finance.
Two conventional means of borrowing money for projects are:
- Equity: Some projects may be financed by promises of equity, a conventional type of financing. Investors receive dividends or capital growth proportional to the percentage of their investment. TV shows such as Shark Tank and Dragon’s Den have removed some of the mystery of how this type of financing works. Some construction projects may be funded by the contractors themselves or by other investors. For example, approximately 20% of the financing of the Eurotunnel or “chunnel” was through equity granted to contractors and private investors.
Equity investments can be higher risk for investors. First, their distributions can only happen after interest and loan repayments are complete. For some projects, this can take many years. In addition, there are only returns if the project is successful. Should the project fail, the entire investment may be lost. As a result, investors providing cash in exchange for equity typically demand higher returns than others investing in projects.
- Debt: Debt involves periodic repayment of the investment, with interest, based on agreed upon schedules, usually in the form of loans or bonds. Debt may be secured by cash or valuable assets, like the way your mortgage is secured by your home. With unsecured debt there is higher risk. If the project fails, the lender or bondholder may not be repaid.
Loans and bonds are also referred to as senior debt. This is because the borrower has an obligation to pay off these types of debt ahead of others. Holders of senior debt can also make the first claims on an organization’s assets in the event of project failure. In addition, debt which is secured must be repaid in any circumstances. If repayment is not possible, the repayment happens when lenders take possession of the cash or assets offered as security. Since unsecured debt carries a higher risk, those providing unsecured debt financing often seek higher rates of return on their investment.
In the event of project failure or failure to deliver planned benefits, an organization may not be able to make payments on their debts. In this case, lenders may renegotiate to become equity holders.
There are also many unconventional means to finance projects. For the purpose of this article, we will only look at two:
- Countertrade: A countertrade is a form of barter arrangement where goods or services are accepted as full or partial payment, in lieu of cash. The recipient needs to sell the goods or make use of the services received to raise funds for the project. Countertrade is most common and popular for startups projects and international projects involving economically disadvantaged countries. The countertrade is useful when there isn’t enough cash to finance the project or if there is an excess of a commodity.
There are four major types of countertrade transactions:
Barter – purchased goods are paid for by other goods.
Compensation - the goods offered in payment are transferred to a third party. The third party may either be a consumer or a seller of these goods.
Buy-back - in exchange for providing an asset, say a factory, needed for an expansion project, the provider agrees to purchase or accept a certain amount of the output of the factory as compensation for setting up the factory.
Counterpurchase - the goods and services acquired are not directly used. Instead they are sent to a third party for sale. In some cases, an exchange that is both like a countertrade and counterpurchase. Some of the goods may be used, while others are sent to a third party.
- Finance Lease: Finance leases are those which transfer the risks and rewards of ownership to the lessee. The lessor acquires the asset and provides to the lessee in exchange for a fixed payment over time. In this manner, the lessee frees up cash for purposes than acquiring a needed asset in exchange smaller fixed payments. Given that projects are usually temporary in nature, it would make sense to lease any working space needed for a project which might be a longer-term project or where the facility could be used for operations later.
When using forms of countertrade, it is important to keep an eye on cash flow, which we examined in a past article: https://www.accidentalpm.online/blog/introduction-to-project-cash-flow. Cash is still needed for operations, so too many countertrades can be harmful.
When in your early career as project manager, knowing how the project has been financed may not be important. As you continue your learning journey, these are additional terms you should know. When you are in a more senior position, knowing the means of financing may be important to managing and controlling project costs.
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