Overview

Steve Jobs and Bill Gates started their respective companies (Apple and Microsoft) in their garages. That makes for a nice story, but how exactly did these companies go from garage-band material to global behemoths? They had to raise money or "capital" somehow - there was only so far that Steve Jobs' own bank account (or his parents' bank account) was going to take him. Eventually, both Jobs and Gates needed to seek additional capital from various sorts of investors to help their companies grow - there is, after all, an old saying that it "takes money to make money." True enough; in this lesson, we will take a bit of a closer look at the process of raising capital, from venture capital to stocks to bonds. The world of corporate finance can get very murky very fast; and, in some ways, it's more of a legal practice than a business practice. Our focus is going to be on understanding the various mechanisms that are used to finance energy projects and the implications of those funding mechanisms on overall project costs.

Where we will ultimately wind up is at this mysterious quantity called the "discount rate." Where does that come from? When we are looking at social decisions that involve common costs and benefits, the discount rate is usually more of a matter of debate than anything else. But when a business decision is involved (and that business is a for-profit entity), then there is a rhyme and reason behind the determination of the discount rate as the "opportunity cost" of its investors. There are many different types of investors in a typical firm or project, all of whom face different opportunity costs, so we will encapsulate these in a single number called the "weighted average cost of capital" (WACC). The WACC turns out to be the correct discount rate for a company or a project.

Finally, most of the material that we will develop in this lesson is targeted toward for-profit companies making investments that are expected to earn some sort of positive return over a relevant time horizon. We won't talk much about the non-profit sector except at the very end, when we discuss how the deregulation of commodity markets has changed the investment game for many for-profit firms, but not necessarily for publicly-owned or cooperative firms. If you are interested specifically in project finance concepts for non-profit firms, the Non-profit Finance Fund has some good resources available.

Learning Outcomes

By the end of this lesson, you should be able to:

• Discuss topics related to Basic Accounting and Corporate Finance
• Explain the fundamental difference between debt and equity financing
• Identify different types of equity investors
• Calculate the cost of debt and equity financing for a single company or project
• Using the cost of debt and equity financing, calculate the weighted average cost of capital
• Determine the client, locale, and major stakeholders for your project
• Develop a preliminary Project Charter and Stakeholder Register for your project

Reading Materials (and a video!)

We will draw on sections from several readings. In particular, there are a number of good online tutorials on the weighted average cost of capital. If you want to get deeper into this subject, there is no substitute for a good textbook on corporate finance. The all-time classic is Principles of Corporate Finance by Brealy, Myers, and Allen (672 pp., McGraw Hill). This book has gone through a number of editions, so earlier editions are probably available online for relatively little cost.

• M.G. Morgan, et al., The U.S. Electric Power Sector and Climate Change Mitigation, Section II (pp. 20-26)
• Business Week, Debt and Equity Financing (This is an article that is geared more towards small businesses but has good concise definitions of "debt" and "equity.")
• G. Krellenstien, Transmission Financing (This presentation presents a clear and frank look at the world of financing energy projects.)
• A primer on Project Finance (Guide to Infrastructure Financing) written by HSBC.
• In Canvas, registered students can access the following: Groobey, C, et al. (2010). Project Finance Primer for Renewable Energy and Clean Tech Projects. Wilson Sonsini Goodrich & Rosati Professional Corp.

Please watch the following video interview with Elise Zoli. If this video is slow to load here on this page, you can always access it and all course videos in the Media Gallery in Canvas.

Once the video begins to play, you can access the transcript for this video by choosing the transcript icon, to the right of the magnifying glass icon, in the upper right corner of the video player.

Video: Interview with Elise Zoli (43:45)

What is due for Lesson 3?

This lesson will take us one week to complete. Please refer to the Course Calendar for specific due dates. Specific directions for the assignment below can be found within this lesson.

• Complete all assigned readings and viewings for Lesson 3
• Project work: Preliminary Project Charter
• Project work: Preliminary Stakeholder Register

Questions?

If you have any questions, please post them to our Questions? discussion forum (not email). I will not be reviewing these. I encourage you to work as a cohort in that space. If you do require assistance, please reach out to me directly after you have worked with your cohort --- I am always happy to get on a one-on-one call, or even better, with a group of you.

A lot of what we will be studying in this lesson falls under the umbrella of "corporate finance," even though our focus is actually individual energy projects, not necessarily the companies that undertake those projects. Still, there are a number of parallels and many concepts of how companies should finance their various activities are immediately relevant to the analysis of individual projects. After all, like companies as a whole, individual projects have capital, staffing, and other costs that need to be met somehow. And a company can sometimes be viewed as simply a portfolio of project activities. Similarly, an individual project can be viewed as being equivalent to a company with one single activity. (Following deregulation in the 1990s, a number of major energy projects, such as power plants, were actually set up as individual corporate entities under a larger "holding company.") A lot of the emphasis in the corporate finance field is how companies should finance their various activities. (For example, in the readings and external references, you will see a lot of mention of "target" financial structures.) That isn't really our focus - we are more concerned with understanding the various options that might be available to finance project activities. The "right" financing portfolio is ultimately up to the individuals or companies making those project investment decisions.

Project financing options are numerous and sometimes labyrinthine. You may not be surprised that lawyers play an active and necessary role (sometimes the most active role) in structuring financial portfolios for a project or even an entire company. While individual finance instruments span the range of complexities, the basics are not that difficult. For an overview, let's go back to the fundamental accounting identity:

$$\text{Assets}=\text{Liabilities}+\text{Owner Equity}$$

The balance sheet for any company or individual project must obey this simple equation. So, if an individual or company wants to undertake an investment project (i.e., to increase the assets in its portfolio), then it needs some way to pay for these assets. Remembering the fundamental accounting identity, if Assets increase, then some combination of Liabilities and Owner Equity must increase by the same dollar amount. Herein lies the fundamental tenet of all corporate and project finance: financing activities that increase the magnitude of Assets must be undertaken through the encumbrance of more debt (which increases total Liabilities) or through the engagement of project partners with an ownership stake (which increases total Owner Equity).

Hence, all projects must be financed through some combination of "debt" (basically long-term loans by parties with no direct stake in the project other than the desire to be paid back) and "equity" (infusions of capital in exchange for an ownership stake or share in the project's revenues).

The following video introduces debt and equity in a little more detail. The article from Business Week , while it goes more into the specifics for small businesses than our purposes require, also has a nice overview of debt and equity concepts.

Video: Debt and Equity Financing (4:51)

Debt and equity each have costs. The cost of debt is pretty explicit - lenders typically charge interest. The cost of equity is a little more complex since it represents an "opportunity cost." If an equity investor (like a potential holder of stock) buys into Acme PowerGen Amalgamated, that investor is foregoing the returns that it could have earned from some other investment vehicle. The attitude of most investors, in the immortal words of Frank Zappa, is "we're only in it for the money." Those foregone returns represent the opportunity cost of investing in Acme PowerGen Amalgamated. If we weight these costs by the proportion of some project that is financed through debt and equity means, we have a number that is known as the "weighted average cost of capital" or WACC. The general equation for WACC is:

$$\begin{array}{c}\text{WACC}=(\text{Fraction financed by debt})\times (\text{Cost of debt})\times (1-\text{Tax Rate})+ \\ (\text{Fraction financed by equity})\times (\text{Cost of equity}). \end{array}$$

Here, the "costs" are generally in terms of interest rates or rates of return. So, a company facing a 5% annual interest rate would have a "cost of debt" equal to 5% or 0.05. We'll get into these pieces in more depth, and will explain the strange tax term in the WACC equation after we gain more of an understanding of debt and equity, and how the costs of debt and equity might be determined.

The term "equity" in corporate or project finance jargon indicates some share of ownership in a company or project - i.e., some level of entitlement to some slice of the revenues brought in by the company or project. There are different priority levels of this entitlement - typically operating costs must be paid (including, in some cases borrowing costs) before equity investors can get their slice of the net revenues. There are also multiple priority levels of equity investors, which determines who gets paid first if profits are scarce.

The simplest, and one of the most common, forms of equity ownership is through the ownership of company stock. A share of stock is simply an ownership right to a portion of the company's profits. When public stock is initially issued by a company (called an "initial public offering"), the price paid for that stock is effectively a capital infusion for the company.

When you think about shares of stock, you may have in your mind things that are traded on the New York Stock Exchange. Not all stock is traded or issued this way, at least not initially. Often, company founders or owners will decide to sell limited amounts of stock in a company without that stock being available for the general public to purchase or being traded on an exchange like the New York Stock Exchange. A company that issues stock in this way is often referred to as being a "private" company, which means that its stock is held and traded (if it's ever traded) in the hands of individuals or institutions selected by the company. Often times, stock in a private company comes with some sort of voting right or other representation into how the company runs its operations.

A company that issues shares of stock to the general public is called a "publicly-traded" or "public" (for short) company. The term "public" in this case should not be confused with ownership by any government or the mission of the company - the term simply refers to the availability of the company's stock. The decision to "go public" is complicated and has costs as well as benefits. The obvious benefit is that issuing public stock is a relatively straightforward way to raise large amounts of capital. Owners of private stock that allow their stock to be sold in the public offering can also make substantial amounts of money if the demand for the stock among the public is high. There are, however, a couple of big down sides. First, issuing more shares of stock effectively dilutes the value of existing shares. If a company has $1 million in profits over a time period and increases the number of shares of stock from 1 million to 2 million, then the earnings per share of the company drops from $1 per share to $0.50 per share over that time period. People are sometimes willing to pay large sums for company stock if they believe that profits will increase in the future. Second, the more equity investors there are (public or private), the larger the loss of control by the company's initial shareholders.

Raising equity capital can happen through a number of different channels. Brief descriptions of a few of the major channels follow:

• Angel investors
  are generally individuals who take equity shares in a company when the company is very young. Often times, friends or family are the original "angel" investors. Angels often take very large stakes in projects or companies, which also gives angels substantial control (in many cases) in how those projects or companies are run.
• Venture capital firms are partnerships that make investments in start-up companies. The big difference between venture capitalists and angel investors is that venture capital firms typically invest in a large number of different start-up companies or projects, and so are more diversified.
• Institutional investors
  represent groups (not individuals) that can invest money in companies or projects. Examples include pension companies, endowments and even universities (interestingly, during the financial crisis in 2008/09, many universities lost billions of dollars when their investments went sour). Sometimes, institutional investors make direct investments on their own, and sometimes they do so as part of venture capital firms. Institutional investors are generally more restrictive in the riskiness of the projects that they can take on than individual venture capitalists or angel investors might be.
• Corporate investors
  represent companies that buy equity interests in other companies. It is very common for large companies to purchase direct stakes in smaller companies or individual projects.
• Tax equity investors
  are especially important to renewable energy projects. These investors provide funds to renewable energy companies or projects in exchange for a share of the tax benefits that those companies enjoy through subsidies and incentives (more on these in Lesson 12). This concept may seem a bit odd - if a company is installing solar PV panels and can claim tax credits for those panels, then why not just claim the credits themselves? The answer is that if the solar PV company is small, then either it does not have a large tax liability in the first place and would not benefit as much from the credits; or it may not be sophisticated enough to wind its way through the maze of tax forms necessary to claim the credits. This is where the tax equity investor comes in. Typically, a tax equity investor will purchase an equity stake in a company (a so-called "joint venture") that is about equal to the value of the tax incentives for that particular investor. Only certain types of entities may act as tax equity investors, and these activities are regulated in the U.S. by the Internal Revenue Service (so-called "passive activity" companies).

The "cost of equity" for a project or company represents the return that an equity investor would need in order to judge that project or company a worthwhile investment. Remember that the cost of equity is really an opportunity cost. Individual investors may have their own criteria for judging opportunity cost, and we can't get into their heads all of the time. So, how do we estimate opportunity cost for a particular project or company? The most common framework is to use a framework called the "Capital Asset Pricing Model" (CAPM). Investopedia has a nice introduction to this framework that includes both the intuition and the equations. Here, we will stick mostly to the intuition.

• First, investments in individual projects or companies are risky, and an investor can always put her money into a safe asset. A bank deposit is typically a safe asset. U.S. treasury bonds are also considered to be pretty safe assets, at least historically. So, the return on equity investment needs to be higher than the return on a safe asset.
• But by how much? One approach that investors sometimes take is to look at similar investments (similar projects or companies) to see how these returns have performed relative to the safe asset. This number is called the "risk premium."
• Finally, there is always some correlation between an individual asset and the market as a whole. This correlation is known as the "beta" and is obtained through statistical analysis of individual project or company returns relative to a market index or average. If a company has a high correlation with the overall market, then returns on that company will be subject to all of the volatility of the market as a whole. In this case, the "beta" for that company would be high, and the cost of equity would also be high.

Using the CAPM to determine the cost of equity, the equation is:

For project evaluation, it is common to use the beta and risk premium relevant to the industry in which the project is going to operate (e.g., utilities for a power plant or gasoline for a refinery). This web page has a nice table estimating the cost of equity for different industries.

Debt financing refers to capital infusions by entities that do not take any ownership or equity stake in the company or project. Debt financing is like a loan - in fact, bank loans are among the most common forms of debt financing for projects and companies. Most debt is "private," in that it is held in the hands of a single entity (like a bank) or group of entities, and transferring that debt to another party is time-consuming. Just as with stocks, there is "public" debt that is traded openly. Many corporations issue various types of bonds that can be traded no differently than stocks.

The big difference between debt and equity financing has to do with repayment. Equity financing is essentially a loan that is "repaid" through entitlements to a stream of future company or project profits. Debt financing involves various terms of repayment. In many cases, holders of debt have priority on repayment before holders of equity interests in a company.

The cost of debt is determined primarily by how likely or unlikely the lender is to be paid back. If a project goes into bankruptcy, for example, holders of debt may not earn back their entire investments. (One of the advantages of being a lender is that in the case of bankruptcy, lenders often have a higher priority for repayment than equity shareholders.) Rating agencies such as Moody's, S&P, and Fitch use ratings as a general indication of the riskiness of debt.

Wikipedia has nice overview tables and charts of what the various ratings mean. For our purposes, the long-term column is more important than the short-term column. The Federal Reserve Bank of St. Louis is a nice resource for finding returns or "yields" on corporate bonds of various grades. Often times, for each step away from the top rating (AAA, for example), investors demand a roughly 0.25% to 0.5% increase in yield in exchange for that increased risk of default, but this is not always the case. (You may see examples when you click on different links for corporate bond return data.) The list of available corporate bond rates from the St. Louis Fed can be dizzying. If you search on the website for the bond grade that you're looking for (like "AAA" or "BB") then you can find information more easily. You can also try using a web search engine by typing in "FRED AAA Corporate bond yield" if you were looking for the AAA bond. A couple of specific examples that you can look at to compare yields are:

• AA Corporate Bond Yield
• BBB Corporate Bond Yield
• CCC Corporate Bond Yield (remember, this means "high yield" but also "high risk"!)

Now that we've covered the basics of equity and debt financing, we can return to the Weighted Average Cost of Capital (WACC). Recall the WACC equation from the beginning of the lesson:

Evaluating the WACC for a company is different than evaluating the WACC for an individual energy project. When the WACC for a company is evaluated, we are often trying to determine (under imperfect information) what a company's costs of capital are. In this case, we would utilize as much financial data as possible in order to estimate the various terms in the WACC equation.

For an individual energy project, the various terms in the WACC equation are determined in large part by the type of investment being made, the type of market (regulated versus deregulated) in which the investment is occurring and the individual company or group of companies making the investments.

The tax rate term in the WACC equation may seem odd. Why discount the tax rate from the cost of debt financing? The reason is that from the perspective of a company, the interest on debt (i.e., the cost of debt) is tax-deductible, so interest payments are offset by tax savings.

Let's go through a hypothetical example to see how this works. Suppose that Mark Linguine PetroServices Amalgamated wanted to invest in a new oil refinery. What is the discount rate that Mark Linguine PetroServices should use in evaluating the NPV of the refinery project? The answer is that the discount rate is equal to the firm's Weighted Average Cost of Capital! So we need to calculate the WACC to determine the discount rate that Mark Linguine PetroServices should use.

Let's assume that 15% of Mark Linguine PetroServices' refinery activity would be financed by debt (just to use a single number). Oil company bonds have historically had very high ratings, so we'll assume that Mark Linguine PetroServices has a long-term bond rating of AAA. Looking online at corporate bond yields, we see that a 20-year AAA corporate bond would have a yield of 2.5% (as of the time of this writing - keep in mind that these rates can and do change frequently).

If Mark Linguine PetroServices faced a 35% marginal tax rate, then its cost of debt financing would be 0.025 × (1-0.35) = 0.02, or 2% (I'm rounding up here - the answer to more significant digits is 1.6%).

Turning now to the cost of equity financing, we need the return on the safe asset; the market risk premium; and the beta for the petroleum industry. The yield on the 30-year treasury bond was 2.34% at the time of this writing. We will assume a risk premium of 5%, and from the "Cost of Capital by Sector" web page we see that the beta for the petroleum industry is between 1.30 and 1.45 (the beta is in the second column of the table; we'll use 1.45 for this example). Thus, the cost of equity for Mark Linguine PetroServices would be 0.0234 + (1.45 × 0.05) = 0.1, or 10% (Again, I'm rounding here - the answer to more significant digits is 9.59%).

Assuming that 15% of the refinery was financed through debt and 85% through equity, the WACC for the Mark Linguine PetroServices refinery project would be:

$$\text{WACC}=0.15\times 0.02+0.85\times 0.10=0.095,\text{ or 9.5\%}$$

The WACC represents the discount rate that a company should use in conducting a discounted cash flow analysis of a given energy project. The reason is that the discount rate represents the opportunity cost of getting something in the future relative to getting something today. Since the WACC represents the average return for an energy project (remembering that that average is weighted across both debt and equity investors), it represents a kind of average opportunity cost for investment in a project.

Please read Section II (Problems in Managing the Restructured Industry) from Morgan, et al. and have a look at the presentation from Gary Krellenstein. Krellenstein's presentation in particular, while focused mostly on transmission investment, raises a number of really important issues regarding how changes in market institutions - such as decontrols on wellhead prices for natural gas, or electricity deregulation - have changed the investment environment for large energy projects. These impacts have perhaps been most evident in electricity, but are not confined to just the electricity sector.

The main idea from both readings is that deregulation has done two things simultaneously. First, it has removed the guarantee of cost recovery from major energy projects such as power plants. (Krellenstein's presentation is focused on transmission because, at the time that it was written, the U.S. federal government was considering proposals to deregulate transmission the same way that it had deregulated generation. In the end, it did not, and most transmission lines continue to enjoy cost recovery ensured by the state or federal government.) This means that energy projects need to earn sufficient revenues to cover costs, plus meet the rate of return demanded by investors. Second, commodity prices in deregulated energy markets are volatile - we have seen this in previous lessons with oil, petroleum products, natural gas, and electricity. Since the revenue stream for energy projects became more volatile, the projects themselves are viewed as being increasingly risky.

The point that Krellenstein makes on slide 13 of his presentation about "system" versus "project" financing sums it up nicely. From an investor's point of view, regulated energy markets are safe because the risks of cost recovery are effectively shifted from the project's owners to the people who pay energy bills. This may not be economically efficient, but from capital's point of view it is safe. Deregulation has shifted some of this risk back to the project's owners (i.e., the company building/operating the plant and its equity shareholders). This is why Krellenstein points out that the majority of "project financed" energy investments are heavily weighted towards debt financing. Since this debt financing is not highly rated (see Figure 3.1, from Krellenstein's presentation), it carries higher yields. The equity component of that financing also becomes more expensive since investors demand returns over a shorter time horizon, as shown in Figure 3.2 (also from Krellenstein).

Figure 3.1: Average credit rating of different types of "electrical" debt.

Credit: S. Blumsack © Penn State is licensed under CC BY-NC-SA 4.0

Figure 3.2. Annual financing costs excluding operating expense and depreciation ($ in millions).

Credit: S. Blumsack © Penn State is licensed under CC BY-NC-SA 4.0

Project Finance is the funding of a specific project or group of projects (like a PV Solar electricity generation project) on a non-recourse basis through a special purpose entity. What does that exactly mean?

1. The lenders to the project do not have access to the assets of the corporation, but only the assets of the project if the project defaults (non-recourse).
2. There is a special purpose entity (SPE) set up to construct, operate and maintain the project(s). This SPE is responsible to also distribute the funds from operations such as expenses, taxes, debt service and returns to equity through the life of the project.

Why do we use project finance?

1. Lower financing costs.
   Because debt is cheaper than equity and a project financed structure can use more debt the overall cost of capital is lower. This makes the project have a higher return. To convince yourself of the benefits of leverage go to this simplified model. Play around with the debt percentages in cells d2 and g2. This shows how higher debt levels can increase returns to equity shareholders. Also please note that above a certain level of debt, the model does not compute a return. This is because, at a certain level of debt, lenders become less willing to capitalize projects if developers do not have some “skin in the game” (bear some risk). You will also see that the interest rate increases on the debt as the leverage goes up. Why do you think the interest on the debt would increase as the leverage increases?
2. Enforces discipline on how the project is developed and managed.
   Because the debt is tied to a specific project, the project developers are required to spend the capital and manage the project subject to covenants agreed to by the lender and developer.
3. Allows greater investment in worthy projects.
   By providing for the financing off the balance sheet and therefore not breaching its corporate debt covenants or other constraints, the developer can raise most of the funds to capitalize the project based on the projected cash flows of the project.

In this lesson, we took closer look at the process of raising capital, from venture capital to stocks to bonds. The world of corporate finance can get very murky very fast; and, in some ways, it's more of a legal practice than a business practice. Our focus was on understanding the various mechanisms that are used to finance energy projects and the implications of those funding mechanisms on overall project costs.

When we are looking at social decisions that involve common costs and benefits, the discount rate is usually more of a matter of debate than anything else. But when a business decision is involved (and that business is a for-profit entity), then there is a rhyme and reason behind the determination of the discount rate as the "opportunity cost" of its investors. There are many different types of investors in a typical firm or project, all of whom face different opportunity costs, so we will encapsulate these in a single number called the "weighted average cost of capital" (WACC). The WACC turns out to be the correct discount rate for a company or a project.

Reminder - Complete all of the Lesson 3 tasks!

You have reached the end of Lesson 3! Double-check the What is Due for Lesson 3? list on the first page of this lesson to make sure you have completed all of the activities listed there before you begin Lesson 4.