FINANCIAL MANAGEMENT PART 2 RN 11.26.

2013
JRM

SOURCES OF FINANCING AND HYBRID FINANCING WITH VALUATION ISSUES

CONTENT CAPSULE:
□ Debt financing
□ Equity financing
□ Hybrid financing: Preference shares, leasing, options, warrants, and convertibles

Introduction
Based on the module on financial forecasting, in order to support an increase in assets, we can either resort to internal
financing or external financing. Let us look once more at the formula which we adapted to compute how much more a
company must raise by issuing debt or new stocks for any increase in assets or investments.

EFN = Assets x ΔSales (P) - Spontaneous Liabilities x ΔSales (P) - PM x Projected Sales x (1- d)
Sales Sales

Projected Increase in Retained Earnings

OR

Projected Increase in Assets Projected Increase in Spontaneous Liabilities Projected Net Income multiplied by
Retention Ratio
Where:
ΔSales (P) = Projected Change in Sales (Peso value)
Spontaneous Liabilities = Liabilities that naturally move up and down with sales
PM = Profit Margin
d = Dividend Payout ratio

In this module, the increase in assets will be deemed a response to a proposal to invest and not only a change to support
operation demands. At the same time, the focus will be on external financing and hybrid financing.

Off-
Balance
ASSETS LIABILITIES CAPITAL
Sheet
Financing
CURRENT LONG-TERM RETAINED ORDINARY PREFERENCE
ASSETS
LIABILITIES LIABILITIES EARNINGS SHARES SHARES
INCREASE
Dependent
in ASSETS
Proportionate on
(supported
to Sales Retention
by
Ratio
operations)
INCREASE Issuances of Issuances of new
in ASSETS Straight debt ordinary shares
(supported securities
by external
financing)
Issuances of:
Issuances of: APIC - Preference
INCREASE
changes:
in ASSETS - Convertibles
Warrants
Shares
(supported - With Outstanding, - Convertibles Leasing
by hybrid
financing)
Warrants Conversion - With
Privileges Warrants

Debt financing

Benefits and drawbacks of debt

The following are advantages of issuing debt securities:

1. interest payments are tax deductible to a firm
2. wise use of debt may lower a firm’s weighted average cost of capital (WACC)
3. during inflation, debt agreements charging a fixed rate is repaid with “cheaper pesos”

The following are disadvantages of issuing debt securities:

1. interest and principal must always be met when due, regardless of a firm’s financial position
CRC-ACE: Securities Valuation and Hybrid Financing page 2
2. poor use of debt may lower a firm’s stock price
3. may place burdensome restrictions on the firm

Valuation of Bonds
The value of the bond is simply the present value of all the security’s future cash flows, as shown below:

Present Value of future cash flows related to bonds = Coupon1 + Coupon2 + …+ Couponn + Face Value
(or Current Bond Issue Price) (1+YTM)1 (1+YTM)2 (1+YTM)n

Periodic Interest Payments Principal Payment

Effective Rate = Approximate = YTM’ = Interest Payment + (Par Value – Net Price)
YTM Number of Years to Maturity
(Net Price x 0.60) + (Par Value x 0.40)

Some important notes one has to remember about bond prices:

a) Bond prices are inversely related to bond yields
b) As interest rates in the economy change, the price or value of a bond changes:
i) if the required rate of return increases, the price of the bond will decrease (inverse)
ii) if the required rate of return decreases, the price of the bond will increase (inverse)

Internal Equity Financing: Retained Earnings

For a time, we had been discussing that retained earnings available for investment is determined by dividend policies,
adapting the “residual dividend model”.

In various stages of business growth, checkout the types of the most appropriate dividends per stage :
Type of Dividends Distributed
Three Basic Types of Dividend
Stage I Development No dividends
Policies: (1) constant pay-out (2)
Stage II Growth Stock dividends, low cash dividends
regular dividend (3) low regular-
Stage III Expansion Stock dividends, low to moderate cash dividends, stock splits
Stage IV Maturity Moderate to high cash dividends and-extra.

Aside from the availability of funds and stability of income generation, other factors affecting dividend policy are as
follows:
1. Legal Rules 4. Desire for Control
2. Cash Position of the Firm 5. Tax Position of Shareholders
3. Access to Capital Markets

External Equity Financing: Ordinary Shares

Valuation of Securities: Basic

The value of the stock is simply the present value of all the security’s future cash flows, as shown below:

Present Value of future cash flows related to stocks = Dividends1 + Dividends 2 + …+ Dividends n + Selling Price n
(or Current Stock Issue Price) (1+ks)1 (1+ks)2 (1+ks)n

Periodic Dividend Payments Proceeds from Selling Stocks,

Affected by growth, g end of definite holding period

Valuation of Securities: Discounted Cash flow Model

Remembering the discounted cash flow model, we can arrive at a simpler presentation of a computation of the current price
of stocks as follows:
ks = D1/P0 + g P0 = D1/( ks – g)

However this model can readily be used only in pricing single growth rate or one-stage growth stocks. The situation is: not
all common stocks grow perpetually at the same rate. Common stock dividends can actually vary. With non-constant
growth stocks, additional steps will have to be done before the DCF model above can be applied as is.

Valuation of Securities: Pricing Issues on Non-Constant Growth Stocks

Let us look into the following problem on pricing non-constant growth stocks.

Last year, Firm A paid P4.00 in annual dividends. This year, a ten percent increase is expected. What if there is an expected
return from common shares in the amount of 12%, and that the dividends are expected to grow by 10% per year for the next
two years, after which the dividends shall move steadily at 5%, at how much should the stocks be sold initially this year?
Using a time line, let us plot how the events are expected to occur:
g = 10% g = 10% g = 5% g = 5% g = 5% ……….

Year 0 1 2 3 4 5 6
D0 = 4.40
 CRC-ACE: Securities Valuation and Hybrid Financing page 3

In order to determine the price of the stocks at Year 0, we are to predict the Present Value of the future cash flows, using
the dividend growth model. (i.e. ks = D1/P0 + g). However, the “g” in this model is “constant”, so what we have to do is
measure the present value of its future cash flows one period at a time until it becomes constant, only then can we use the
DGM conveniently.

Step 1: Compute for the EXPECTED DIVIDENDS, using the expected growth rates
g = 10% g = 10% g = 5% g = 5% g = 5% ……….

0 1 2 3 4 5 6
D0 = 4.40 D1 = 4.84 D2 = 5.32 D3 = 5.59 D4 = 5.87 D5 = 6.16 D6 = 6.47
Step 2: Identify the HORIZON DATE.
The horizon date is the date when the dividend starts to grow at a constant growth rate. In this case, the ‘horizon date’ is…
g = 10% g = 10% g = 5% g = 5% g = 5% ……….

0 1 2 3 4 5 6
D0 = 4.40 D1 = 4.84 D2 = 5.32 D3 = 5.59 D4 = 5.87 D5 = 6.16 D6 = 6.47
Step 3: Compute for the present values of the Future Cash flows, since this will approximate the value of the stock, which in
turn is used to establish its price. Use the ks as the discounting rate.
g = 10% g = 10% g = 5% g = 5% g = 5% ……….

0 1 2 3 4 5 6
D0 = 4.40 D1 = 4.84 D2 = 5.32 D3 = 5.59 D4 = 5.87 D5 = 6.16 D6 = 6.47
?
CF1=?
???? ????

a. Expected dividends at Year 0 PRIOR to the horizon date.

g = 10% g = 10% g = 5% g = 5% g = 5% ……….

0 1 2 3 4 5 6
D0 = 4.40 D1 = 4.84 D2 = 5.32 D3 = 5.59 D4 = 5.87 D5 = 6.16 D6 = 6.47
0.8929
CF1=4.32
???? ????

b. Expected Cash flow at horizon date (or simply, {Expected dividends at horizon date + price of the stocks at horizon
date}) The stock’s price at horizon date is equal to the expected future cash flows starting that day onwards.
g = 10% g = 10% g = 5% g = 5% g = 5% ……….

0 1 2 3 4 5 6
D0 = 4.40 D1 = 4.84 D2 = 5.32 D3 = 5.59 D4 = 5.87 D5 = 6.16 D6 = 6.47
0.8929
D1=4.32 Expected + Constant growth rate of 5%
P2 = ? Dividend

???? CF2 = ?

To substitute,
P2 = D2 + 1 = P 5.59 = P 79.86  Price at end of Year 2
0.12 -0.05 0.07
g = 10% g = 10% g = 5% g = 5% g = 5% ……….

0 1 2 3 4 5 6
D0 = 4.40 D1 = 4.84 D2 = 5.32 D3 = 5.59 D4 = 5.87 D5 = 6.16 D6 = 6.47
0.8929
CF1=4.32

P2 =79.86
 CRC-ACE: Securities Valuation and Hybrid Financing page 4
CF2=67.91 0.7972
CF2 =85.18

Step 4: Compute for the PRICE OF THE STOCK at Year 0 by adding the present values of the Future Cash flows.
g = 10% g = 10% g = 5% g = 5% g = 5% ……….

0 1 2 3 4 5 6
D0 = 4.40 D1 = 4.84 D2 = 5.32 D3 = 5.59 D4 = 5.87 D5 = 6.16 D6 = 6.47
0.8929
CF1= 4.32
P2 =79.86
CF2= 67.91 0.7972
CF2 =85.18
CF2=72.23 
Note to the Candidate: What if for example, the question is to compute for the price of the stocks at end of Year 1, instead
of Year 0, can you now compute for the stock’s price?(0.12(5.32/ (0.12-0.05)-0.05)) = P 76

Summary of Points on Non-constant growth stocks:

To find the value of a stock with non-constant growth, follow these four steps:
1. Partition the dividend stream into a beginning period of non-constant growth followed by a period of permanent
constant growth.
2. Find the present value of the dividends during the period of non-constant growth.
3. Find the expected value of the stock at the end of the non-constant growth period (the beginning of the constant growth
phase), and then find the present value.
4. Add these two components to determine the present value of the stock, P o.

Valuation of Securities: Price-Earnings Model

Price-Earnings ratio is in substance the reciprocal of return on investment. Given a P/E ratio at a respective point in time
and predicting the EPS will allow estimation of stock’s price:
P0= EPS0 x P0/EPS0
Remember that when a high P/E ratio is registered:
1. It is an indication of positive expectations for the future of the company
2. It means the stock is more expensive relative to earnings
3. It typically represents a successful and fast-growing company
4. The company’s stock is called a “growth” stock

However, a stock with a low P/E ratio:

1. It indicates negative expectations for the future of the company
2. It may suggest that the stock is a better value or buy
3. The company’s stock is called “value” stock

Valuation of Securities: Effects of Splits and Repurchases

Method Description Effect On
Number of Outstanding Stock Price
Shares
Stock split More than one new share are Increase Lower, though increasing
exchanged for an old share slightly immediately after
split
Reverse Stock split Less number of new shares are
Lower Increase
exchanged for several old shares
Stock Repurchases Buying back formerly issued shares Lower Increase

Spread in Security Issuances

Whether the company issues debt or equity securities, it usually incurs cost in issuances, or spread.

Spread = [(Price to Public – Amount Paid to Issuing Firm) / Amount Paid to Issuing firm] x 100
= compensation to those who are participating in the distribution

Bid-Ask spread = [(Ask price – Bid price) / Ask price] x 100

Notes on Spreads
1. The lower a party falls in the distribution hierarchy, the lower the portion of the spread received.
2. Usually, the larger the pesos value of an issue, the smaller the spread.
3. The spread on equity issues is greater than on debt issues because of the greater price uncertainty.
CRC-ACE: Securities Valuation and Hybrid Financing page 5

Hybrid financing: Preference shares, leasing, options, warrants, and convertibles

Hybrid securities are either debt or equity financing that possesses characteristics of both debt and equity.

Preference share
A comparison of ordinary stock and bond issuances to preferred shares:
Ordinary Stock Bonds Preference Shares1
Ownership and control of With voting rights and Limited rights in case of Limited rights when
the firm residual claim to income default dividends are 
missed
Obligations to provide None Contractual obligations Must receive before
return ordinary 
shareholders
Claim to assets in Lowest Highest claim After creditors
bankruptcy 
Cost of distribution Highest Lowest Moderate

Risk-return trade off Highest risk, highest return Lowest risk, Lowest return Moderate risk,
Moderate return 
Tax status of payment by Not deductible Tax- deductible Not deductible
issuing entity 
Leasing
The process by which a firm can obtain the use of certain fixed assets for which it must make a series of contractual,
periodic, tax deductible payments.

Potential benefits from leasing

1. Firm need not to have to borrow or use its liquid resources to purchase the asset
2. Provisions of a lease obligation may be less restrictive than a bond indenture
3. There may be no down payment requirement (generally required when purchasing an asset).
4. Firm avoids cost of obsolescence.

Types of Leases
1. Capital Lease (or Financing Lease):
a. a purchase rather than a lease
b. firm actually buys the property
c. must be shown on a firm’s balance sheet
d. examples include: oil drilling equipment and airplanes

2. Operating Lease:
a. a conventional rental agreement
b. firm doesn’t expect to own property
a) is not shown on a firm’s balance sheet
b) examples include: automobiles and office equipment

Convertibles
A conversion feature is an option included as part of either a bond or preferred stocks issue and allows its holder to change
the security into a specific number of shares of common stocks.

Convertibles usually have a call feature of convertibles allowing issuers to retire or force conversion paying a call price to
holders usually lower by 10 to 15% than the conversion value of the security. Convertibles that cannot be forced into
conversion are known as “overhanging issue”.

Ideally, the cost of convertibles are lesser than that of straight equity, but higher than straight debt. (kd < kc < ke )

Valuation of convertibles
Naturally, convertibles can be sold higher than straight securities.
VPackage = VStraight security + VConversion

Conversion Price = Pc = Par value of convertible ÷ Number of shares received per conversion
= Pc = Par value of convertible ÷ Conversion Ratio (CR)
= Pc = usually higher than the price of the ordinary share in the convertible issuance date

Conversion value = Ct = CR(P0)(1 + g)t

Conversion value = Market Price of Ordinary Share – Conversion Price

1
Primary purchasers are corporate investors, insurance companies, and pension funds; Primary issuers are public utility
companies, acquiring firms, and firms experiencing losses.
CRC-ACE: Securities Valuation and Hybrid Financing page 6
Floor price = The floor value is the higher of the straight security value and the conversion value
= The floor value is the minimum price at which the convertible would be traded

Advantages of issuing convertible securities:

1. Issuer can include lower interest rate than on a straight bond and still the convertible security will be attractive.
2. Issuer can include more relaxed covenants than on a straight bond and still the convertible security will be attractive.
3. Issuer does not have to give up immediate control.
4. It may be the only means for a small corporation to gain access to the bond market.

Disadvantages of issuing convertible securities:

1. Size of a convertible offering is usually very small.
2. A potential dilution of EPS may happen.
3. Conversion brings in no new funds.

Warrants
Warrant is an option of the holder to buy a stated number of shares of stock at a specified price over a given time period (a
long-term option to buy stock). The specified exercise price is typically set at 10% to 30% above the current stock price on
the issue date.

Although it appears that warrants “sweetens” a bond offering, it still has a cost (i.e. equal to the opportunity cost from
selling at a higher price than the exercise or striking price).

1. is usually detachable from the bond issue

2. is highly speculative, as its value is dependent on the market movement of the stock
3. has a large potential for appreciation if the price of the stock goes up

Uses of warrants:
1. Enhances a debt issue by allowing for the issuance of debt under difficult circumstances
2. May be included as an add-on in a merger or acquisition agreement
3. Can be issued in a corporate reorganization or bankruptcy to offer shareholders a chance to recover some of their
investment
4. Traditionally has been associated with speculative real estate companies, airlines, and conglomerates

Valuation of warrants
Naturally, securities with warrants can be sold higher than straight securities.
VPackage = VStraight debt + VWarrants

Conversion value = Market Price of Ordinary Share – Striking Price

VWarrants = Conversion value + Premium

Theoretical value of a warrant = TVW = (P0 - E) x N

Where:
P0 = Current Market price of stock
E = Exercise price
N = Number of ordinary shares acquired with one warrant.

Options
Options provide the holder with an opportunity, but not the obligation, to purchase or sell a specified asset at a stated price
on or before a set expiration date. Three basic options are rights, warrants, and calls and puts.

Call option is an option to buy securities at a stated price on or before a set expiration date. Put option is an option to sell
securities at a stated price on or before a set expiration date. They are hybrid securities but they are not a source of fund for
the company. The presence of call and put options may stabilize the firm’s share price by increasing trading activity, but
one must understand, many factors affect share price in the market.

/jrm