Project Finance & Financial ModellingCapital structure, risk allocation and bankability · Lesson 4 of 20
Capital structure, gearing and the cost of capital
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Capital structure, gearing and the cost of capital
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0:00 Leverage: the double-edged sword
Here's a puzzle. Two identical solar plants earn exactly the same cash each year. One investor earns nine per cent on her money. The other earns twenty-one per cent. Same asset. Same cash. How? The difference is capital structure: how much of the project was funded with debt, and how much with equity. Leverage can more than double equity returns. It can also wipe equity out when things go wrong. In this lecture you'll learn the capital stack and the order of repayment, how gearing is measured, exactly why leverage magnifies returns and risk, how to calculate the weighted average cost of capital, the main instruments used in project finance, including Islamic finance, and why hedging matters. By the end, you'll be able to explain to a board why the capital structure is a risk decision as much as a funding decision.
1:02 Why it matters
Why does this matter? Because the capital structure decides who gets paid first, who absorbs losses first, and what the whole project costs to finance. It also decides how resilient the project is. A highly geared project looks wonderful in the base case and can become fragile in a downside case, when a small fall in revenue leaves nothing for equity, or not enough to cover debt service. Lenders know this, which is why they impose coverage ratios and reserves. Sponsors need to know it too, because the most attractive-looking structure on paper can be the one that fails first in practice.
1:46 The concept: the capital stack
Picture the capital stack like seats on a lifeboat. Senior secured debt sits at the top. It's repaid first from cash flows and has first claim on security, so it accepts the lowest return. Below it, mezzanine or subordinated debt, paid after senior debt, earning more. Then shareholder loans, sponsor funding that ranks behind senior debt, often used for tax reasons. And at the bottom, ordinary equity. It's paid last, as dividends only after debt service and reserves, and absorbs losses first. So it demands the highest return. Gearing, or leverage, is usually measured as debt divided by debt plus equity, based on total project cost. Contracted infrastructure with strong offtakers can often support high gearing, while projects with merchant or volume risk support less. And here's the key idea: gearing is usually a cap. Lenders actually size debt from cash-flow coverage, which we'll cover later.
2:49 Worked example one: the leverage table
Let's do the numbers from the lesson. A project costs one hundred and earns a steady nine a year. Debt costs six per cent, and we'll ignore tax for simplicity. All equity: nine divided by one hundred, a nine per cent return. Fifty per cent gearing: fifty of debt costs three in interest, leaving six for fifty of equity. Twelve per cent. Eighty per cent gearing: eighty of debt costs four point eight, leaving four point two for twenty of equity. Twenty-one per cent. That's the magic of leverage: debt costs less than the project earns, so equity keeps the difference. Now the other edge. If the project's return falls to five, the eighty per cent geared equity earns five minus four point eight, point two, on twenty. One per cent. A further drop wipes it out. Same leverage, opposite effect.
3:50 Worked example two: WACC for a Gulf project
Now the weighted average cost of capital, or WACC. The formula: the debt share times the cost of debt times one minus the tax rate, plus the equity share times the cost of equity. With illustrative numbers: seventy per cent debt at eight per cent before tax, a twenty per cent tax rate, and thirty per cent equity requiring fifteen per cent. The debt term is nought point seven times eight per cent times nought point eight: four point four eight per cent. The equity term is nought point three times fifteen: four point five per cent. WACC is about nine per cent. Two cautions. First, interest tax deductibility depends on local law; some jurisdictions have limited or zero corporate tax for certain entities, and some restrict interest deductions. Second, don't use a company's corporate WACC for a project whose risk is very different.
4:53 Watch me do it: a gearing and returns sheet
Let me show you a quick sheet that makes the double edge visible. Three inputs: project cost, project return and debt rate. Across the columns, gearing from zero to eighty-five per cent in five per cent steps. Debt is gearing times cost. Interest is debt times the rate. Equity is cost minus debt. And equity return is project cash minus interest, divided by equity. Then I add a second row for a downside case, with project return at five per cent. Look at the chart. In the base case, equity return climbs steeply with gearing. In the downside row, it falls, and at the highest gearing levels it goes negative. That single chart explains why lenders cap gearing and test downside cases, better than any paragraph I could write.
5:49 Instruments and Islamic finance
What instruments fund the stack? Commercial bank loans are flexible, with floating or fixed rates, and are common in construction. Project bonds offer longer tenors and fixed rates, attractive for operating assets with stable cash flows. Export credit agency cover supports loans linked to equipment exports and can extend tenor. Development finance institutions, multilateral and bilateral, are active in emerging markets, often with environmental and social standards attached. Islamic finance is widely used in the Gulf and Pakistan: structures such as ijara, a lease, istisna'a, a construction financing, murabaha, a cost-plus sale, and sukuk, sharia-compliant certificates. The legal form differs from conventional interest-bearing debt, though the economic analysis of the cost of funds is similar. And sponsors use equity bridge loans to defer injecting equity, and shareholder loans that rank behind senior debt.
6:47 Hedging and common mistakes
Two financial risks need special attention. Interest rates: floating-rate debt exposes the SPV to rate rises, so lenders typically require a large share to be hedged with interest rate swaps. And currency: if revenue is in local currency but debt is in dollars, a devaluation can make debt service unaffordable. That's a major risk in some emerging markets, addressed through tariff indexation, local-currency debt or hedging. The common mistakes: maximising gearing without testing downside cases; ignoring currency mismatch between revenue and debt; treating shareholder loans as equivalent to equity without checking their tax and legal ranking; and using a corporate WACC for a project with very different risk.
7:34 Recap and try this now
Let's recap. The capital stack sets the order of repayment and loss: senior debt first, equity last. Gearing measures the share of debt, and leverage magnifies equity returns when the project earns more than debt costs, and magnifies losses when it doesn't. WACC weights the after-tax cost of debt and the cost of equity, and should reflect the project's own risk. Instruments range from bank loans and bonds to ECA cover, DFI loans and Islamic structures, and interest rate and currency risks need hedging or structural answers. Your try-this-now: recreate the leverage table for a project return of seven per cent and a debt cost of six per cent. At what gearing does the equity return exceed twelve per cent? And what happens to that structure if the project return drops to five and a half?
What capital structure means
Capital structure is the mix of funding sources used to pay for the project: senior debt, subordinated (mezzanine) debt, shareholder loans and equity, and sometimes grants or export credit agency support. The structure determines who gets paid first, who bears losses first, and the overall cost of capital.
The capital stack
Priority of repayment (highest first) Risk / required return
┌──────────────────────────────────────┐
│ Senior secured debt │ Lowest
├──────────────────────────────────────┤
│ Mezzanine / subordinated debt │
├──────────────────────────────────────┤
│ Shareholder loans │
├──────────────────────────────────────┤
│ Ordinary equity │ Highest
└──────────────────────────────────────┘Senior lenders are repaid first from cash flows and have first claim on security. Equity is paid last (dividends only after debt service and reserves) and absorbs losses first, so it demands the highest return.
Gearing
Gearing (leverage) is usually expressed as debt ÷ (debt + equity), based on total project cost. Illustrative ranges: contracted infrastructure with strong offtakers can support high gearing (often in the 70–85% range), while projects with merchant or volume risk support less. Actual levels depend on market conditions, lender appetite, country risk and the strength of cash flows; lenders ultimately size debt from cash flow coverage (covered in module 4), and the gearing ratio acts as a cap.
Why leverage increases equity returns
Illustrative. A project costs 100 and produces a steady project return of 9% a year. Debt costs 6% (after considering tax effects for simplicity, ignore tax here).
| Structure | Debt | Equity | Annual cash after interest | Equity return |
|---|---|---|---|---|
| All equity | 0 | 100 | 9.0 | 9.0% |
| 50% gearing | 50 | 50 | 9.0 − 3.0 = 6.0 | 12.0% |
| 80% gearing | 80 | 20 | 9.0 − 4.8 = 4.2 | 21.0% |
Leverage magnifies returns because debt costs less than the project earns. But it also magnifies risk: if the project return falls to 5%, the 80% geared equity earns (5.0 − 4.8)/20 = 1%, and a further drop wipes it out. That is why lenders impose coverage ratios and reserves.
Weighted average cost of capital (WACC)
WACC = (D/V) × Kd × (1 − tax rate) + (E/V) × Kewhere D = debt, E = equity, V = D + E, Kd = cost of debt, Ke = cost of equity.
Illustrative. 70% debt at 8% pre-tax, tax rate 20%, 30% equity at a required 15%: WACC = 0.7 × 8% × 0.8 + 0.3 × 15% = 4.48% + 4.5% ≈ 9.0%.
Note that interest tax deductibility depends on local tax law, which varies (some jurisdictions have limited or zero corporate tax for certain entities, and some restrict interest deductions). Islamic finance structures, common in the Gulf and Pakistan, replace interest with profit-sharing, lease (ijara) or cost-plus (murabaha) arrangements; the economic analysis of cost of funds is similar, though the legal structure differs.
Instruments at a glance
| Instrument | Key features |
|---|---|
| Commercial bank loans | Flexible, floating or fixed rates, often hedged; common in construction |
| Project bonds | Longer tenors, fixed rates; attractive for operating assets with stable cash flows |
| Export credit agency (ECA) cover | Supports loans linked to equipment exports; can extend tenor |
| Development finance institutions (DFIs) | Multilateral and bilateral lenders active in emerging markets, often with environmental and social standards |
| Islamic finance (e.g., ijara, istisna'a, sukuk) | Sharia-compliant structures widely used in the Gulf and Pakistan |
| Equity bridge loans | Short-term loans that defer equity injection, backed by sponsor guarantees |
| Shareholder loans | Sponsor funding ranking behind senior debt, often tax-efficient |
Hedging
Floating-rate debt exposes the SPV to interest rate rises; lenders typically require a large share to be hedged with interest rate swaps. Currency mismatches (e.g., revenue in local currency, debt in USD) are a major risk in some emerging markets and must be addressed via indexation in tariffs, local-currency debt or hedging.
Common mistakes
- Maximising gearing without testing downside cases.
- Ignoring currency mismatch between revenues and debt.
- Treating shareholder loans as equivalent to equity without checking tax and legal ranking.
- Using a corporate WACC for a project with very different risk.
Hands-on: a leverage and downside sheet in Excel
Inputs: Cost (100), Proj_ret (9%), Down_ret (5%), Kd (6%)
Row 1 Gearing 0%, 5%, … 85% across C1:T1
Row 2 Debt =C1*Cost
Row 3 Interest =C2*Kd
Row 4 Equity =Cost-C2
Row 5 Equity return =IFERROR((Cost*Proj_ret-C3)/C4, "")
Row 6 Downside return =IFERROR((Cost*Down_ret-C3)/C4, "")
WACC =D_share*Kd*(1-Tax)+E_share*KePlot rows 5 and 6 against gearing: the fan shape shows why lenders cap gearing and test downsides.
Hands-on: the same in Python
import numpy as np
cost, kd = 100.0, 0.06
gearing = np.arange(0.0, 0.86, 0.05)
debt = gearing * cost
equity = cost - debt
for label, proj_ret in [("base 9%", 0.09), ("downside 5%", 0.05)]:
eq_ret = (cost * proj_ret - debt * kd) / equity
print(label, " ".join(f"{g:.0%}:{r:+.1%}" for g, r in zip(gearing[::4], eq_ret[::4])))
d, kd_pre, tax, e, ke = 0.70, 0.08, 0.20, 0.30, 0.15
print(f"WACC {d * kd_pre * (1 - tax) + e * ke:.2%}") # ≈ 8.98%How to measure success
- Every proposed structure is shown with base and downside equity returns.
- Currency and interest-rate exposures are identified with a hedging or structural response.
- The discount rate used for appraisal reflects the project's risk, not the sponsor's corporate WACC.
Key takeaways
- The capital stack ranks funding by repayment priority; equity is last and riskiest.
- Gearing = debt ÷ (debt + equity); lenders cap it but size debt mainly on cash flow coverage.
- Leverage magnifies equity returns when debt costs less than the project earns, and magnifies losses too.
- WACC = (D/V)·Kd·(1−t) + (E/V)·Ke; adjust for project risk and local tax and financing structures.
Check your understanding
Quick questions to lock in the lesson. They don’t count towards your certificate.
Put it into practice
Recreate the leverage table for a project return of 7% and debt cost of 6%. At what gearing does the equity return exceed 12%?
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