Although there are a number of rural investment funds directed solely at non-profit investments, the majority of financing provided to communities and individual applicants in the rural sector also contemplate the financing of activities that generate income; that is to say, profit-oriented activities. Although they might receive subsidies, investments in income generating projects almost always require that the recipient(s) accept part of the cost of the investment in the form of a loan.
In this section, we characterize the different needs for reimbursable (or repayable) financing and discuss the loan features that can influence the cost of financing.
Credit or loans are required to finance two basic costs, and can be calculated as follows:
Investment Loans: The total cost of the investment less (i) any grant funds offered by the supporting agency; (ii) donations from other sources (e.g. NGOs, government, churches etc.), and (iii) personal resources provided by the applicants.
Working Capital: Funds to cover operating expenses (as defined in Chapter 6) less donations and personal resources.
The availability of donated funds will depend on the supporting agency and its resources. In many cases, in addition to covering the cost of the field technicians assisting in the preparation of the investment proposal, grant funds are also available to reduce or eliminate the cost to the applicants of human resources and systems development (training, designing accounting systems, etc.) and for environmental studies and mitigation measures. In some cases, a supporting agency may offer grants or subsidies for investments in what are called ‘common goods’ - that is items that can be used by a wide range of people, such as access roads, water collection works, etc. Less frequently, a supporting agency might subsidize the cost of productive investments or working capital for the operation of these investments.
One warning about the excessive use of donations and subsidies: Although they might appear to be very attractive to the applicant, he or she must be careful to ensure that the product would continue to be feasible or profitable even if these grants or subsidies were not available. Why? Because when the time comes to replace the investments, the project may not be able to cover these new costs and can fail. Thus there is a real risk of undertaking an unsustainable project.
Although the question of financial feasibility tends to apply more to income generating projects than to social or environmental investments, it should not be forgotten in these cases, either. For these non-income generating projects, donations frequently cover most, if not all, the investment cost. When the time comes to repair the roof, or replace the furniture, there are simply no resources available to cover the cost.
A certain level of personal contribution on the part of the applicants is important, and is generally required by the financial agency. A significant contribution of personal or community capital (in cash or kind) demonstrates the borrower’s commitment to the project, and insures that, if it fails, the borrower will also suffer from the loss of his or her own capital.
1. Financing for investment
Investment financing normally occurs through single credit with a loan duration of 4 to 5 years or longer. Typically, in small and medium sized projects, a single loan is obtained to cover the total amount. However, in larger projects, it may be wise to split the cost of the investment into two amounts, especially if land is purchased. One loan can cover either land or other long term investments with long life spans (structures, heavy machinery, etc.). The second can be used for investments with short to medium life spans (vehicles, electronic equipment, etc.). On this basis, two loans would be requested, each with a different payback period, and probably interest rate.
It may also be the case that the financing agency imposes limitations regarding the type of items that it will consider, (for example, it might not allow loans to finance the purchase of vehicles). In this case it might be useful to divide the financing into two parts: the majority of the costs to be financed would be covered by the supporting agency, while alternative sources (e.g. commercial bank, cooperative, savings and loan association, etc.) would be sought for the financing of the excluded items.
2. Financing working capital
Loans for financing working capital are always short term. They may be ‘rolled over’, or renewed, from one year to the next but are rarely extended beyond one year. Thus, if there is a need to continue to use external financing for working capital in the second year, it would be more customary to pay off the current year’s loan at the end of the year, and then obtain a fresh one for the following year.
This short term nature of working capital loans affects the way that the loan is recorded in the accounts of the project. Given that the loan is both received and then paid back within the same year, the only element of a working capital loan that appears in the annual accounts is the interest cost of the loan. The actual loan amount will neither appear as an income nor as an outstanding capital debt as would be the case for an investment loan - only the interest payment remains. This is illustrated below in comparison with an investment loan.
|
Amounts |
Loan Investment |
Working Capital |
|
Borrowed at the beginning of the year |
$ 2,000 |
$ 200 |
|
Principal repaid at the end of the year |
$ 400 |
$ 200 |
|
Interest paid (at 10%) |
$ 200 |
$ 20 |
|
Principal outstanding |
$ 1,600 |
$ 0 |
It is impossible to carry out a financial analysis of an investment without defining some of the key characteristics of the loans involved. Among these features, the most important are the interest rate, the grace period and the duration of the loan.
a) Interest rate
Interest rates will be determined by the financial agency that supports the investment. In some cases, these rates will be subsidized. Normally, the interest rate for a medium or long term loan (for investment) will be different from the rate for a short term loan (working capital). As RuralInvest works with constant costs and prices, real - rather than nominal - interest rates should be used for medium and long term loans. The importance of this, and why it is done, is discussed in more detail later in this Chapter.
b) Grace period
A grace period is the time during which the borrower need not make payments on his loan. It is common for even commercial banks to offer grace periods for medium and long term loans, but it is rare for them to do so for short term credit.
There are two types of grace period. The first refers only to the payment of the loan capital. This is the most common. During the grace period on principal, interest is fully paid by the borrower but the principal (or capital amount) remains untouched. Thus after one year, the borrower owes the same amount as at the beginning. The second type of grace period refers to interest. In this case, the interest is not paid, but instead is added to the principal, thereby increasing the total amount of the loan. Grace periods on interest are less common than on the principal and, if offered, tend to be shorter. A bank or other lender may, however, offer to provide six months or one year’s grace on interest where it is clear that no income will be generated in the first months of the project.
It is important to understand that neither of these two types of grace period signify the forgiveness of any part of the loan. They only postpone payment, and where interest payments are not made, will actually increase the size of the debt.
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FINANCING THE PURCHASE OF A COMPUTER The managers of a small business finally decide that the time has come when they can no longer survive without a computer to keep their accounts straight and to prepare their invoices. They determine that a computer (with its printer, software and other necessities) will cost an equivalent of US$5,000. They estimate that the equipment will have a useful life span of 4 years and will have no significant resale value at the end of its life. If the rate of interest on the loan is 10% per year, what will be the impact of taking out a US$5,000 loan for 2, 4, or 6 years? |
|||
|
|
2 years |
4 years |
6 years |
|
Annual Payment: |
2,881 |
1,577 |
1,148 |
|
Total Payment: |
5,762 |
6,309 |
6,888 |
|
You can see that the annual payment is almost double for the two year loan compared to the four year package; that is, although the total cost of the loan for 4 years is US$547 more than that of the 2 year loan (because interest is paid over a longer time period), the annual cost is US$1,300 less. The 6 year loan is even cheaper in annual terms: only US$1,148. However, at the end of the fourth year, when the computer must be replaced, the company will still owe US$2,300 and must now also finance the cost of replacement. |
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c) Duration of the loan
The ideal loan is one that lasts just as long as the item being financed. However, in real life, loans are used to buy a series of goods, each with its own life span. So, you must define a period that covers the majority of the investments; especially the most important of them, in terms of cost.
If the loan has a shorter term than the life of the article being purchased, the project will have to find a larger amount each year in order to pay it off quickly. However, if the loan lasts longer than the item, the project could find itself in a position where it is starting a new loan to finance a replacement, while it has still not yet finished paying off the original loan (see box).
In any case, the life of a loan for investments should not be longer than the period of analysis of the project. If the nature of the goods and the project itself justify a 20 year loan, then it is necessary to analyse a period of 20 years.
As we mentioned earlier, a possible definition of a project is "an investment today in order to generate a flow of benefits in the future". However, this difference in time - the investment today and the benefits tomorrow - causes complications. We all recognize the fact that something received in the future is worth less than the same thing received right now. For this reason, it is not possible to say that a project is feasible simply because its future income is greater than the present investment. Everything depends on the relative value of the money (or other benefits) today and in the future.
Below, we will consider the impact of time on the value of money and describe how to take this fact into account when analysing an investment.
1 Inflation and Future Value
When we speak of the difference between money today and in the future, many people immediately think of inflation.
It is true that when there is inflation, the future value of money is less, as a consequence of the rise in prices. However, the methodology used by RuralInvest attempts to eliminate the impact of inflation by calculating all of the elements of the project in terms of constant prices. That is to say, it is assumed in the analysis that the prices of all goods, inputs, labour, products, etc. will stay the same during all of the years analysed. Thus, if a day of work in the workshop or school costs $2.50 in the first year, it will cost $2.50 throughout the period of the analysis, even if it is 20 years.
How is it possible to do this? The answer is that although it is probable that the costs will rise with the passing of the years, the prices received for the sale of the products will also rise. So the rise in costs will balance out the increase in income, and there will not be a significant distortion in the results[12]. Excluding inflation from the calculation eliminates the need to calculate new costs and prices for each year of the analysis, an exercise that may well be justifiable in projects involving multi-millions, but not in small or medium sized investments.
However, inflation is not the only factor that makes something in the future less valuable than today, and entices us all to prefer something now than in an uncertain future.
According to The Economist magazine, prices in Europe in 1914, at the beginning of the First World War were not, on the average, higher than they were in the 17th Century; that is in 200 years there had been no inflation. But the banks in Europe continued offering positive interest rates for deposits during this entire period, although often no more than 2 or 3% per annum. So, even without inflation, people demanded some compensation (the interest rate) for waiting until the future to have their funds.
Below we discuss what factors influence interest rates in the absence of inflation.
2. Constant Prices and the Real Interest Rate
If constant prices are to be used for inputs and products, they should also be used for the cost of money; that is, the interest rate, as interest rates are heavily influenced by inflation, both actual and expected. For medium and long term loans, therefore, the model used by RuralInvest deducts the current inflation rate from the ‘nominal’ interest rate (that is the one paid by the client), thereby leaving a "constant" or "real" interest rate.
The question of real interest rates on loans is the area which presents RuralInvest users more difficulties than perhaps any other. To understand how inflation affects the interest rate, let us consider the different elements that combine to determine the rate charged by a lender (bank, cooperative, project, etc.):
a) The initial cost of the funds: the price that a bank or other lender pays the deposit holders whose money they use;
b) The cost of administering the loan: this is commonly the highest cost for small loans, as it takes almost the same time to process a loan for $500 as it does for $500,000;
c) The risk of loss or delays in payment: this varies with the kind of security offered by the client and how well the bank knows the client;
d) The profit margin required by the bank: the part of the loan cost that generates profits for the bank.
Expectations concerning the inflation rate over the life of the loan clearly influences at least two of these elements - the cost of funds and the bank’s profit margin. To compensate for any decrease in the value of funds due to inflation (either the bank’s own funds or those of its depositors), the bank will have to increase these two elements, increasing the overall interest rate.
Where inflation rates are significant, there can be a major difference between nominal and real rates. In fact at very high inflation rates, real interest rates will often drop below zero, because it takes some time for people to believe that inflation will stay so high into the future.
It is very important to be clear about one thing. The use of a ‘real’ interest rate (that is one that excludes inflation) helps us to determine the underlying feasibility of the project - it does not tell us how much the project will pay every month or year to the financing agency. That is not its purpose, although a user can get some idea of these actual payments by setting the inflation level to zero in the RuralInvest software. This will force the computer to make the ‘nominal’ interest rate equal to the ‘real’ rate, and the payments calculated will be thus be at the nominal rate.
Even if the nominal rate is used, however, extreme care must be taken in assuming (or even worse, telling the applicants) that the amounts calculated by RuralInvest are those that the project will pay once underway. This is because there are many ways to schedule repayments, as well as to incorporate associated loan charges. For example, while it is common to equalize payments over the life of the loan (as is done with mortgages and in RuralInvest), this is not essential, and some lenders will vary payments according to the amount outstanding, which will mean high payments in the early years. Still others will ‘balloon’ payments at the end, resulting in low costs early on, but high costs towards the end of the loan period. All involve the same interest rates, but result in a quite different pattern of payments. In a similar manner, some agencies will charge cash for loan services, while others will add them to the loan amount, or to the early payments, and so forth. Thus, the loan payments calculated in RuralInvest are not a good guide to actual payments that will be faced by a project.
In theory, the same method of eliminating inflation could be used for working capital, but the relation between constant prices and real interest rates is less clear over short periods, because some prices respond more quickly than others. For this reason, in the case of less-than-one-year loans, the models use current interest rates, which give us a higher cost than necessary; but it is considered better to take a conservative position.
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[12] In fact, in the absence
of very different inflation rates among the different elements of the project,
probably the most important impact in using constant prices found in the
underestimation of the needs for working capital. |
