Methods of Financing Lecture No 49 Chapter 15 Contemporary Engineering Economics Copyright © 2016 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved 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 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Methods of Financing o Equity Financing o Debt Financing o Capital Structure o Capital is coming from either retained earnings or funds raised from an issuance of stock o Money raised through loans or by an issuance of bonds o Well managed firms establish a target capital structure and strive to maintain the debt ratio th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Equity Financing • Flotation (discount) costs – The expenses associated with issuing new securities • Types of equity financing o o o Retained earnings Common stock Preferred stock th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved 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? th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved 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 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Debt Financing • • Bond Financing: o May incur floatation cost o No partial payment of principal o Only interest is paid each year (or semiannually) 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 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 15.2: Debt Financing by Issuing Bonds Given: Scientific Sports, Inc (SSI) needs to finance $10 million by issuing a mortgage bond o o o o Face value = $1,000 Market price = $985 Coupon rate = 12% interest payable annually 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 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved 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 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved 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 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 15.3: Project Financing Based on an Optimal Capital Structure Given: oSSI’s capital structure = 0.50 oRaise $5M by issuing common stock and $5M by issuing bonds at 12% interest Floatation cost Stock: 8.1% Bond: 3.2% o • • Find: Project cash flows th Contemporary Engineering Economics, edition Park oProject Description •Life: years •Building: $3M •Equipment: $6M •Land: $1M •Cash dividend: $2 per share •Unit production cost: $50.31 •Unit price: $250 •Annual O&M cost: $600,000 •Annual demand: 20,000 units •Working capital: $500,000 Tax rate: 40% Copyright â 2016 by Pearson Education, Inc All Rights Reserved Solution th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved ... Rights Reserved Methods of Financing o Equity Financing o Debt Financing o Capital Structure o Capital is coming from either retained earnings or funds raised from an issuance of stock o Money... 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 th Contemporary... Education, Inc All Rights Reserved Equity Financing • Flotation (discount) costs – The expenses associated with issuing new securities • Types of equity financing o o o Retained earnings Common