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Financing a Project Through Debt, Equity and Stock

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Question: What are the advantages and disadvantages to using a combination of debt, equity and stock to finance a project?

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In over 800 words, this solution details the advantages and disadvantages of particular approaches to financing a project. Examples are used to provide further support to this solution.

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A project can be financed by any of the capital funds viz. long term debt (say Corporate Bonds), preference stock, common stock and retained earnings. The basic factor is the cost of funds and the risks attached to it. If a project is accepted at a particular cost of capital then, firstly, it should be able to meet its business risk i.e. it should be able to cover its operational costs, secondly, it should be able to meet its financial risk i.e. it should be able to meet the financial obligations like interest, lease payments, preferred stock dividends etc. Lastly, the cost of capital is calculated on an after tax basis.

While a firm may try to obtain one source of fund, say long term debt, thinking that post tax its cost of capital is low, but all funding have limitations. The supplier of fund would certainly look in to the risks associated with the firm in meeting its obligations and therefore either the cost of capital would become higher or it may not be able to get the funds up to the desired level of financing. The long term debt suppliers look at the firm's financial position and ascertain whether firm would be able to service its debt promptly. Besides several other aspects and financial ratios, they will more specifically look in to their leverage ratio, debt service coverage ratio etc. In order to have satisfactory financial parameters that encourage long term debt suppliers to provide funds, the ...

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