Utilizing a Self-Financing Strategy for Projects

Tito Cardoso*

In this paper, a self-financing strategy is proposed to provide continuity of investments in scenarios of restricted
access to capital. The strategy divides project scope into individual units capable of autonomous production,
implemented sequentially in phases. Each phase "pays" for the implementation of successor phases. We demonstrate
that the proposed strategy can be effective in enabling projects under conditions of constrained access to capital and
can reduce substantially the capital required.

Barriers to capital access are experienced by companies due to several variables, such as policies to raise interest
rates, increased risk perception in certain markets, or loss of financial attractiveness at certain times—for example,
in moments of falling prices in commodities markets, among others. The expansion of business in a commodity
market is subject to the effect of commodity international price cycles. Even industries in which products are priced
based on annual contracts suffer the effects of long-term price volatility. For example, price volatility in iron ore can
be observed in Figure 1.1 Specifically, the chart shows that the price of iron ore fluctuated greatly from late 2010
until mid-2016, ultimately dropping by nearly 63 percent during that period.

Figure 1 – Iron Ore Iron Price in USD - Historical Prices.2

When commodity prices are low, there is a capital constraint for business expansion. In the Brazilian market, for
example, low expectations about economic growth resulted in a reduced level of investments.3 Specifically, Figure 2
shows that gross fixed capital formation in Brazil declined significantly between 2014 and 2017.

* Tito Cardoso is a director at BRG based in São Paulo, Brazil. He is a master engineer who has more than 20 years of experience
with effective results in large multinational firms, where he has been accountable for strategic logistics projects and held roles
including capex risk management global practice leader and corporate project management officer.
1
Business Insider, “Iron Ore Price Commodity,” Markets Insider, accessed February 16, 2017, at
http://markets.businessinsider.com/commodities/iron-ore-price
2
Ibid.
3
Trading Economics, “Brazil Gross Fixed Capital Formation,” accessed February 16, 2017, at:
https://tradingeconomics.com/brazil/gross-fixed-capital-formation

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 Figure 2 – Brazil Gross Fixed Capital Formation in BRL Million.4

Without capital, projects may be unviable or delayed. A strategy called self-financing has demonstrated its viability
for the continuity of investments in industrial projects in scenarios where access to capital is restricted.

The Self-Financing Strategy

A proposed strategy for dealing with limited access to capital consists of modulating a project in autonomous
productive units—parallel production lines are the most elementary form of this concept—and splitting into stages
the construction that, in another scenario, could be performed at one time.

By modifying the project according to this “split into stages” logic, the operating revenue margin obtained by the
production of a previous phase can be reinvested fully in the implementation of the subsequent phase. The
reinvestment reduces or—as we will see in the following criterion—eliminates completely the need for additional
capital throughout the project. In other words, the project is paying for itself from the end of the first phase.

Figure 3 shows the effect of this project-modulating approach (the nomenclature used will be detailed in the next
topic) on cash flow.

4
Ibid.

2
 Figure 3 – Cash Flow from a Self-Financing Strategy.

The Self-Financing Criterion

A project planned according to this strategy and according to the following criterion is self-financing:

Eq. 1:

The derivation of this criterion admits the following simplifying approximations:

 Each phase consumes 1/F of the total capex of the project, Cpx, where F is the number of phases in which
the project was divided. In other words, phasing divides the investment in equal parts and does not increase
or decrease the total investment needed to implement the enterprise.
 After each phase is implemented, plus 1/F of the operating revenue margin, M, starts to be billed; that is, the
phases are identical in capacity and billing and are not considered ramp-up periods.
 Each phase consumes  of the time it would take for startup, Sup, if the enterprise were deployed in a single
phase.  can assume values in the range of 0 to 1. If  = 1 and F = 3, the implementation of the enterprise in
three phases should consume three times the time of implementation.

The Potential of Self-Financing

The term to the right of equation 1 informs the maximum percentage of total capex that could be self-financed. Then
the owner can use the criterion to determine the project phasing necessary to constrain the available investment.
For example:

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  For F = 3 phases ( = 1), 66.7 percent of the capex can be self-financed. That is, to implement the entire
project, the owner needs to have only one-third of the total capital.
 For F = 4 phases ( = 1), self-financing may increase to 75 percent of total capex. The owner must have
available only one-quarter of the total capex necessary to implement the entire enterprise.
Figure 4 shows the evolution of the level of self-financing that can be obtained following this strategy.

Figure 4 – Level of Self-Financing by the Phasing Logic

Determination of the Margin Needed for Self-Financing

The criterion allows determining the value of the operating margin required so that the project implementation can
be phased in "F" phases. For example:
For F = 3 phases ( = 1), the owner obtains M = 2/3 (Cpx/Sup). If the investment required to implement the entire
enterprise is US $1.0 billion over three years, then if the project is divided into three phases, a margin of US $222.2
million per year will be required for the entrepreneur to implement the entire venture with only US $333 million
of capital.
For F = 4 phases ( = 1), M = 1/2 (Cpx/Sup). Therefore, for the same $1.0 billion project implemented in three years,
dividing it into four phases, a margin of US $166.7 million per year allows the owner to implement the entire project
with only US $250 million capital.

Feasibility of Self-financed Projects

The strategy of dividing the enterprise into individual productive phases allows the project to "get paid" and is thus
self-financed and requires a smaller amount of initial capital. However, the self-financing strategy increases the time
for total production and postpones the period in which full revenues will be obtained.
Although the derived model considers that the total investment and margin are not changed with the phasing, this
postponement reduces the net present value (NPV) of the project. The more the project is divided into phases, the
more its value is reduced. To illustrate this effect, Figure 5 shows the change in the NPV of a US $1.0 billion project

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with an operating margin of US $250.0 million when its initial implementation in three years is divided into various
amounts of autonomous productive phases.

Figure 5 – Example of Reduction of NPV as a Function of Phasing

The project value reduction can be a reasonable price to pay if the entrepreneur does not have the total capital
needed without applying the self-financing strategy. The owner faces a tradeoff between a lower overall value of the
project and upfront costs of finance.

Reversal of Project Value Loss

The effect of loss of value can be reversed by reducing the time required to deploy each individual phase. In the
derived model, this reduction is described by the variable . Whenever <1, the time of an individual phase is less
than the time required to deploy the full project at one time.
To evaluate the effect of loss of value, this paper will describe the cash flow with and without self-financing, where:

VPI is the present value of the investment

VP (M) is the present value of the margin
t is time
i is the annual discount rate
F is the number of phases
Sup is the time for implementation of the enterprise at one time and
(Sup) is the time to implement a phase, where  is the time-reduction factor of implementation of a phase,
being able to assume values in the range of 0 to 1

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 1) Usual scenario, without self-financing:

Eq. 2:

Eq. 3:

2) Scenario with self-financing, in autonomous productive phases:

Eq. 4:

Eq. 5:

Eq. 6:

To establish the present value of each scenario, in addition to the same simplifications adopted to derive the
criterion of self-financing, we add:
 The VP(M) is calculated in perpetuity; i.e., VP(M) t = M/i.
 The VPI is described as a function of the capex by VPI = . Cpx, where  is a form factor that describes the
investment disbursement curve. For example, an investment of US $1.0 billion, disbursed in three years

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 (20 percent in the first year, 45 percent in the second year, and 35 percent in the last year), has a VPI at
10 percent of US $820 million, or  = 0.82.
Applying this model for the same project of Cpx = US $1.0 billion of total investment, margin M = US $250 million,  =
0,80, discount rate i = 10 percent year shows that reducing the implementation time of a phase can reverse the loss
effect from postponing revenues. Assume (for the same project) implementation time Sup = 3 years and vary  in a
realistic range of values. Table 1 shows that reducing the implementation time of a phase between 60 percent and
70 percent of the total time can reverse the effect of postponing full revenues, recovering or even increasing the
value of the project.

Table 1 – Variation of the NPV for the Selected Project, considering its reduction with increasing phasing (F) versus increasing
NPV with the reduction of the average construction cycle of each phase ().
[Green cells identify scenarios in which the project increases its value by more than 10 percent in relation to the base case.]

Final Considerations

Decision Time for the Strategy

The decision to implement a project according to the self-financing strategy should be made at the beginning of
project development, because this decision directly reflects the design of the project engineering—dividing the
implementation into phases, and the implementation of each phase as an autonomous (i.e., fully functional)
operating unit. A self-financed project will more closely resemble a set of complete and independent plants/lines on
a shared site rather than a single plant with different lines at certain stages of the process.

Recommended Risk Mitigation

 Market: For any capital project, the longer the implementation time, the greater the exposure of the project
value to price volatility.
o Products and key inputs for operations: To mitigate the risk of rising prices, it is recommended to
guarantee, through long-term agreements, the sale of production, increasing as the phases are being
implemented until the conclusion of the entire project. Different trade arrangements and awards
may be proposed to make such agreements viable.
o Services and materials for project implementation: To mitigate the risk of rising costs, as the phases
are deployed sequentially and the deadline for implementation of the entire enterprise is extended,
the self-financing strategy creates the option to establish long-term agreements, such as for supply
of services and/or materials for deployment.
 Industry competition: Every capital project is implemented from a window of opportunity identified in the
market. Competing projects can capture this opportunity, partially or totally, during the time necessary to

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 implement various phases of the enterprise. The mitigation and conversion of this threat into opportunity
consist of accelerating the implementation of the first phase (the  factor of the model). If the first phase is
implemented significantly faster than it would be possible to deploy an entire enterprise, the opportunity is
partially captured in advance, reducing exposure to the threat of competitors by 1/F of the opportunity
identified at each phase implemented.
 Access to resources for operations: Although the autonomous productive units are deployed one at a time,
sequentially, certain rights related to land, waste disposal areas, water use rights, etc. necessary for the
whole enterprise likely must be guaranteed as soon as the first stage is implemented. This risk-mitigation
measure covers the risks of lacking resources during the implementation of the last phases of the enterprise,
either by speculation or by competition from other enterprises for the same resources.

Conclusion

We have proposed a strategy named self-financing, which involves dividing the scope of a project into units capable
of autonomous production, sequentially deployed in phases, where each constructed phase "pays" the
implementation of successor phases. The proposed strategy can be effective in enabling projects when access to
capital is limited and can reduce the necessary capital to between 50 percent and 80 percent of the total investment
(see Figure 4).
We established a criterion for calculating the operating margin in function of the number of phases; the more the
deployment is split, the less initial capital is needed (i.e., the greater the self-financing of the project).
The project value loss effect due to the postponement of full billing can be reversed by reducing the implementation
time of each phase in the range of 60 percent to 70 percent of the initial deployment time.
Additional advantages of the strategy may include that:
 The implementation of identical sequential phases in scope and capacity can result in a learning-curve effect.
With this concept, the  would be accelerated with each new phase, reducing more and more the time of
implementation of a phase.
 Deployment in smaller sequential phases enables more detailed and effective project control, with relatively
small owner and project management costs and greater predictability than would be observed when
deploying the entire enterprise at once.
 The smaller size of each individual phase reduces the risk of deployment and increases the number of
qualified suppliers.
 A real option may be preserved. If the project can be divided, presumably, the next phase of the project can
be delayed or never implemented in a way that might not be possible if a decision is made to move forward
with the full project at the start.