Lecture no49 methods of financing

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Contemporary Engineering Economics, 6th edition

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Methods of Financing

Lecture No 49

Chapter 15

Contemporary Engineering Economics

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Chapter Opening Story

Laredo Petroleum Holdings has approved a

$1 billion capital budget for 2014, which will

be funded from internally generated cash

flow and borrowings from senior securities.

At issue : Because of the size of financing

involved, the firm financing method will

affect the firm’s capital structure, the

cost of capital, and financial risk.

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Methods of Financing

o Equity Financing

o Capital is coming from either retained earnings or funds raised from an issuance of stock.

o Debt Financing

o Money raised through loans or by an issuance of bonds.

o Capital Structure

o Well managed firms establish a target capital structure and strive to maintain the debt ratio.

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Equity Financing

• Flotation (discount) costs

– The expenses associated with issuing new

securities

• Types of equity financing

o Retained earnings

o Common stock

o Preferred stock

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Example 15.1: Equity Financing by Issuing Common Stock

Given :

o Scientific Sports, Inc (SSI) needs to finance $10 million to develop and produce a new metal golf driver.

o Share price for the new stock offering = $28

o Floatation cost = 6% of the issue price

Find : How many shares must SSI sell to net $10 million?

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Solution

o (0.06)($28)(X) = 1.68X

o Sales proceeds − flotation cost = Net

proceeds

28X − 1.68X =$10,000,000

26.32X = $10,000,000

X = 379,940 shares.

1.68(379,940) = $638,300

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Debt Financing

• Bond Financing :

o May incur floatation cost

o No partial payment of principal

o Only interest is paid each year (or

semi-annually).

o The principal (face value) is paid in a

lump sum when the bond matures.

• Term Loan :

o May involve an equal repayment

arrangement

o May incur origination fee

o Terms negotiated directly between

the borrowing company and a

financial institution

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Example 15.2: Debt Financing by Issuing Bonds

Given : Scientific Sports, Inc (SSI) needs to finance $10 million by issuing a mortgage bond.

o Face value = $1,000

o Market price = $985

o Coupon rate = 12% interest payable annually

o Floatation cost = 1.8% of the issue price

Find : (a) Number of bonds to be sold to net $10 million? (b) the total annual interest

payment

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Solution

(a ) To net $10 million, SSI would have to sell:

$10,000,000/(1 − 0.018) = $10,183,300 worth of bonds and pay $183,300 in flotation costs Since the $1,000 bond would be sold at $985, a 1.5% discount, the total number of bonds to

be sold would be:

$10,183,300/($985) = 10,339

(b) For the bond financing, the annual interest is equal to:

$10,338,380 (0.12) = $1,240,606

Only the interest is paid each period, and thus the principal amount owed remains unchanged.

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Capital Structure (Debt Ratio)

• Definition: The means by which a firm is financed.

• Mixed Financing: Capital is raised by borrowing from financial institutions and

by issuing stocks and/or using retained earnings.

• Target Capital Structure: Set a target debt ratio by considering both business risk and expected future earnings.

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Example 15.3: Project Financing Based on an Optimal Capital Structure

 Given:

o SSI’s capital structure = 0.50

o Raise $5M by issuing

common stock and $5M by

issuing bonds at 12%

interest.

o Floatation cost

• Stock: 8.1%

• Bond: 3.2%

 Find: Project cash flows

o Project Description

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Solution

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