One of the reasons that I like Third Avenue Funds, is that every quarter the fund’s chairman and portfolio managers write intelligent, compelling letters to the shareholders. I learn something each time I read these letters. In the Q3 2014 letter, Third Avenue Chairman Marty Whitman includes this paragraph on the difference between Project Finance and Corporate Finance:
In analyzing cash flows, it is super important that the analyst distinguish between project finance and corporate finance. Project finance looks at periodic net cash flows with a defined termination date. For any project to make sense it has to be based on forecasts of a positive Net Present Value (NPV), i.e., the present worth of the cash flows to be received over the life of the project plus cash to be received at the termination of the project, if any, has to be greater than the present worth of the cash costs involved with the project.
In contrast, in corporate finance, one looks at the wealth creation to be realized by a business entity with a perpetual life. Wealth creation is a result not only of successful operations but also judicious investing and having attractive access to capital markets.
While individual projects have to have a positive NPV to make sense, corporations with a perpetual life don’t. CIT and GE Capital provide good examples of the interplay between project finance and corporate finance. Each receivable issued by CIT or GE Capital (i.e., loans to customers) is designed to have a positive NPV. This is project finance. But as the CIT or GE Capital receivables portfolio expands as net new loans are written, the companies become cash negative. This is corporate finance. The cash shortfalls are met by CIT or GE Capital by accessing capital markets – issuing new debt, commercial paper, bank loans and sometimes equity.