On balance sheet
The capital purchase of a CHP plant will appear on the company’s balance sheet as a fixed asset. A capital purchase is generally funded using internal sources, external (debt) finance finance or a mixture of both. Another option is to lease a CHP rather than purchase it.
With internal funding, the company provides the capital for the CHP installation. In so doing, it retains full ownership of the project and should reap the maximum potential benefits. At the same time, the company bears a considerable element of technical and financial risk, although the degree of this risk can vary with the installation option chosen. For instance, where a company places the work with a turnkey contractor, the contract terms may reduce the risk the company has to bear by placing more of it on the contractor. Similarly, the terms of contracts with consultants, equipment suppliers and subcontractors can be designed to minimise the investment risk.
A large capital purchase is often funded by a new debt plus some internal funding. As with full internal financing, the residual technical and financial risks remain with the investing company, apart from those that lie with suppliers and contractors. At the same time, the company retains the full benefits of the installation.
With new debt, it is possible to match an appropriate source of capital to a specific project. In particular, the borrowing timescale can be matched to the timescale of requirements, i.e. short-term finance should be obtained for short-term cash needs and long-term finance for long-term needs such as a CHP plant.
For example, if a company investing in a CHP plant intends to generate a flow of savings/income over a period of 15 years, that company should attempt to finance the plant over the same period. If this is not possible, then the borrowing timescale should, at least, be as long as the payback period for the project plus the period required for recovering the ‘cost of money’. In this way, the repayment schedule can be financed out of the savings/income generated by the CHP system.
The Prospective Lender's Viewpoint
When a company obtains finance, it should bear in mind that the lender regards the loan as an investment.
For every investment, there is a trade-off between risk and return: the higher the risk associated with an investment, the higher the return required on that investment.
Factors influencing the perceived risk and return include:
- The company's current level of borrowings.
- The credibility of the company's projections of project benefits.
- The confidence of the lender in the company.
- The confidence of the lender in the technology to be employed.
- The level of security that can be offered by the company - the lender normally requires security so that the amount of the loan can be recovered if the company fails.
- The confidence of the lender in the general economic situation.
Leasing is a financial arrangement that allows a company to use an asset over a fixed period. There are three main types of arrangement:
- Hire purchase, a
- Finance lease (also known as ‘lease’ or ‘full pay-out lease’) and an
- Operating lease (also known as ‘off-balance-sheet’ lease).
Under a hire purchase agreement, the purchasing company becomes the legal owner of the equipment once all the agreed payments have been made. For tax purposes, the company is the owner of the equipment from the start of the agreement. The basis of the finance lease arrangement is the payment by the company of regular rentals to the leasing organisation over the primary period of the lease. This allows the leasing organisation to recover the full cost – plus charges – of the equipment. Although the company does not own the equipment, it appears on the balance sheet as a capital item and the company is responsible for maintenance and insurance.
At the end of the primary lease period, either a secondary lease – with much reduced payments – is taken out, or the equipment is sold second-hand to a third party, with the leasing organisation retaining most of the proceeds of the sale.
Internal financing is not necessarily an easy option. Although CHP is a long-term investment, it will often have to compete with other potential business projects that are closer to the company’s core area activities. Furthermore, it may have to compete within a short-term appraisal environment. So obtaining approval for CHP as a self-financed project may prove to be a problem.
Although a company normally pools all of its existing sources of finance so that it is not possible to state which one has been used to fund which new project, each form of capital nevertheless has a cost associated with it. It is therefore usual to calculate a composite rate that represents the average cost of capital weighted according to the various sources of finance. This rate is known as the weighted average cost of capital (WACC).
With finance leasing, the leasing organisation obtains the tax benefits, and these are passed back, in part, to the company in the form of reduced rentals. In principle, the rental can be paid out of the energy savings, thereby assisting cash flow. Finance leasing may have tax advantages over internal and debt financing if the company has insufficient taxable profits to benefit from the tax allowances available on capital expenditure.
With this route, the level of financial and technical risk taken on by the company is similar to that of a self-financed project.