What are the risks of using debt financing for a project?

1 Interest rate risk

One of the risks of using debt financing is that the interest rate on your debt may change over time, affecting your cash flow and profitability. For example, if you have a variable-rate loan, your interest payments may increase if the market rate goes up. Alternatively, if you have a fixed-rate loan, you may miss out on the opportunity to lower your interest payments if the market rate goes down. To manage this risk, you can choose a debt structure that matches your project's cash flow profile, such as a fixed-rate loan for a long-term project or a variable-rate loan for a short-term project. You can also use hedging instruments, such as swaps or options, to lock in a favorable interest rate or protect yourself from adverse rate movements.

3 Currency risk

A third risk of using debt financing is that you may face currency risk if your debt is denominated in a different currency than your project's revenues or expenses. Currency risk arises from the fluctuations in the exchange rate between the two currencies, which can affect your cash flow and profitability. For instance, if you have a debt in US dollars and your project's revenues are in euros, you may suffer a loss if the euro depreciates against the dollar. Conversely, if you have a debt in euros and your project's expenses are in US dollars, you may incur a higher cost if the euro appreciates against the dollar. To mitigate this risk, you can choose a debt currency that matches your project's cash flow currency, or use hedging instruments, such as forwards or futures, to fix the exchange rate or limit the exposure.

4 Inflation risk

A fourth risk of using debt financing is that you may face inflation risk if the inflation rate in your project's location is higher than the inflation rate in your debt's location. Inflation risk occurs when the purchasing power of your project's cash flow declines relative to the purchasing power of your debt payments, reducing your real return. For example, if you have a debt in Japan and your project is in Brazil, you may lose money if the inflation rate in Brazil is higher than the inflation rate in Japan. To cope with this risk, you can adjust your project's cash flow projections and discount rate to account for the inflation differential, or use inflation-linked debt or inflation swaps to hedge against inflation.

5 Political risk

A fifth risk of using debt financing is that you may encounter political risk if your project is located in a country or region that is unstable, volatile, or hostile to foreign investors. Political risk refers to the possibility of adverse changes in the political environment, such as expropriation, nationalization, civil war, terrorism, corruption, or regulatory changes, that can affect your project's operations, cash flow, or assets. To reduce this risk, you can conduct a thorough political risk analysis and due diligence before entering a market, and diversify your project portfolio across different countries or regions. You can also seek political risk insurance or guarantees from multilateral agencies or governments, or include political risk clauses in your debt contracts.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?