Module 2 Sources of Intermediate and Long-Term Financing

ALDERSGATE COLLEGE FINANCIAL MANAGEMENT 2
SCHOOL OF BUSINESS AND ACCOUNTANCY

MODULE 2: SOURCES OF INTERMEDIATE AND LONG-TERM FINANCING: DEBT AND EQUITY
Posttest
I. Questions
1. What are some specific features of bond agreements?
The bond agreement specifies such basic items as the par value, the coupon rate, and
the maturity date.
2. Take the following list of securities and arrange them in order of their priority claims:
Preference share Subordinated debenture

Ordinary share Senior debenture
Senior secured debt Junior secured debt
senior secured debt,

junior secured debt,
senior debenture,
subordinated debenture,
preferred stock,
common stock.
3. What method of “bond repayment” reduces debt and increases the amount of ordinary
shares outstanding?
Conversion of bonds to common stock through either a convertible bond or an exchange

offer.
4. Discuss the advantages and disadvantages of debt.
The primary advantages of debt are:

a. Interest payments are tax deductible.
b. The financial obligation is clearly specified and of a fixed nature.
c. In an inflationary economy, debt may be paid back with cheaper dollars.
d. The use of debt, up to a prudent point, may lower the cost of capital to the firm.
The disadvantages are:

a. Interest and principal payment obligations are set by contract and must be paid
regardless of economic circumstances.
b. Bond indenture agreements may place burdensome restrictions on the firm.
c. Debt, utilized beyond a given point, may serve as a depressant on outstanding
common stock.
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II. Multiple Choice Questions
D 1. Increases in total long-lived assets should not ordinarily be financed by
a. long-term debt.
b. equity,
c. spontaneous increases in liabilities.
d. short-term debt.
(CMA, adapted)
D 2. A company is growing a rate of 10 percent per year. This growth requires increases
in accounts receivable, inventory and plant and equipment. Under normal business
financing policy this growth would be funded by
a. the allowances for depreciation.

b. increases in current liabilities.
c. increases in shareholders’ equity.
d. increases in current liabilities, long-term liabilities and shareholders’ equity.
D 3. Private placements have many advantages over public debt issues. Which one of the
following is a disadvantage for the debtor of a privately placed debt issue?
a. Private placements go through a time-consuming process of SEC registration

and approval.
b. Private placements have less flexibility and take longer to arrange.
c. The placement costs are greater than the flotation costs of a public issue.
d. The interest costs of private placements are generally higher than those of public
issues.
(CMA, adapted)
B 4. Investors in long-term corporate bonds are concerned about interest rate risk. This
risk reflects
a. the increased probability of bankruptcy during periods of high interest rates.

b. the decrease in bond prices as interest rates rise.
c. the probability that a bond issue will be called when interest rates fall.
d. the chance that the corporation will default on the interest payments.
(CMA,
adapted)
A 5. Subordinate debentures are securities that
a. rank lower than or are inferior to all other bonds and to senior debt.
b. rank lower than or are inferior to the claims of ordinary shareholders.
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c. are not to be used in situations in which the investments are risky.
d. are legally required to pay interest only to the degree that interest is earned each
year.
e. rank lower than or are inferior to all first mortgage bonds but not to other
mortgage bonds.
(CMA,
adapted)
C 6. A financial instrument which promises to repay the principal at a specified date but
will pay interest only when earned is called
a. a non-participating preference share.

b. a revenue bond.
c. an income bond.
d. a mortgage bond.
(CMA,
adapted)
C 7. Which of the following does not help to explain the existence of a premium in the
price of a convertible bond?
a. The downside protection offered by the convertible that is unavailable with the
stock.
b. The opportunity to participate in gains in excess of the return available to debt
holders.
c. Higher transaction costs on convertibles than the cost of trading ordinary shares.
d. Restrictions on the ability of certain institutions to invest in ordinary shares.
(CMA,
adapted)
E 8. A convertible debenture is used
a. as a sweetener when raising capital by debt instruments.

b. to sell ordinary shares at prices higher than those prevailing when funds are
needed.
c. when low cost capital is needed during construction.
d. when capital cannot be raised by a straight debt instrument at a reasonable rate.
e. for all of the reasons enumerated above.
(CMA,
adapted)
D 9. The least desirable of the following forms of financing for a small corporation whose
shareholders are concerned about maintaining control over the firm is
a. a rights offering.
b. participating preference share.
c. subordinated debentures.
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d. income bonds.
(CMA,
adapted)
B 10. A firm floats a new stock issue and uses the proceeds from the issue to retire a bond
issue which has matured. Which one of the following statements will hold in all
cases?
a. The firm has increased its operating leverage.

b. The firm has decreased its financial leverage.
c. The firm has increased its earnings per share.
d. The firm has decreased its earnings per share.
C 11. Which of the following statements properly describes an advantage of ordinary

shares over long-term bonds as a source of financing?
a. Ordinary share is less costly, and liquidity risk is less.

b. Ordinary share is less costly, and current owners retain control.
c. There is less liquidity risk with ordinary shares, and financing flexibility is
maintained.
d. There is lower underwriting cost with ordinary shares, and financing flexibility is
maintained. (CMA, adapted)
D 12. Using an investment banker to underwrite a firm’s ordinary shares issue means that
a. private placement rather than a public offering will be made.

b. the investment banker guarantees to the public that the ordinaiy share is a good
buy.
c. the issuing firm bears the risk of fluctuating market prices and economic
conditions during the stock issue.
d. the investment banker buys the stock from the firm at a negotiated price and then
resells it to the public.
(CMA, adapted)
D 13. Which one of the following would be most likely to cause an immediate
increase in primary earnings per share?
a. A merger.
b. A conversion of convertible bonds.
c. An exercise of warrants.
d. Purchase of treasury stock.
(CMA, adapted)
A 14. The preemptive right
a. gives holders of ordinary shares first option to purchase additional ordinary

shares.
b. gives bondholders first claim on assets in liquidation.
c. gives preference shareholders the right to vote at annual meetings.
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d. gives bankers the right to demand prepayment of the principal amount of a loan.
(CMA, adapted)
D 15. A rights offering will probably fail
a. if the new issue is small compared to the total ordinary shares outstanding.
b. if the issue has shown price stability over the past year
c. if the stock is very widely held.
d. if the subscription price is close to the market price.
(CMA, adapted)
D 16. Dion Inc. plans to issue 500,000 new ordinary shares through a rights offering. Each
ordinary shareholder will be entitled to subscribe to one additional ordinary' share at
P60 a share for each 4 shares held. The 2,000,000 shares currently outstanding
have a market price of P75. What is the theoretical value of one share when it goes
ex-rights?
a. P75.00
b. P63.00
c. P71.25
d. P72.00
(CMA,adapT
C ed) 17. Which of the following is not an advantage for leasing an asset rather than
purchasing the asset with funds from a term loan?
a. The avoidance of the risk of technological obsolescence.

b. The lack of restrictive borrowing covenants.
c. The terminal value of the asset goes to the lessee.
d. The lease payment is fully tax deductible.
The following information applies to items 18 to 20.
A firm must choose between leasing a new asset or purchasing it with funds from a term loan.
Under the purchase option, the firm will pay five equal principal payments of P1, 000 each and
6% interest on the unpaid balance. Principal and interest are due at the end of each year for five
years. Alternatively, the firm can lease the asset for five years at an annual rental cost of P1,
400 with payments due at the beginning of each year. The corporate tax rate is 35% and the
appropriate after-tax cost of capital is 12%.
B 18. Which of the following is closest to the present value of the after-tax interest
payment?
a. P360.
b. P453.
c. P640.
d. P726.
A
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19. Which of the following is closest to the present value cost of leasing the new asset?
a. P3, 674.
b. P3, 779.
c. P3, 849.
d. P3, 992.
C 20. Which of the following is closest to the present value cost of purchasing the new
asset with a term loan?
a. P3, 777.
b. P3, 952.
c. P4, 058.
d. P4, 153.
A 21. In capital markets, the primary market is concerned with the provision of new funds
for capital investments through
a. New issues of bond and stock securities.

b. Exchanges of existing bond and stock securities.
c. The sale of forward or future contracts.
d. New issues of bond and stock securities and exchanges of existing bond and
stock securities.
C 22. The term “underwriting spread” refers to the
a. Commission percentage an investment banker receives for underwriting a

security issue.
b. Discount investment bankers receive on securities they purchase from the
issuing company.
c. Difference between the price the investment bank pays for a new security issue
and the price at which the securities are resold.
d. Commission a broker receives for either buying or selling a security on behalf of
an investor.
B 23. In general, it is more expensive for a company to finance with equity capital than with
debt capital because
a. Long-term bonds have a maturity date and must therefore be repaid in the future.
b. Investors are exposed to greater risk with equity capital.
c. The interest on debt is a legal obligation,
d. Equity capital is in greater demand than debt capital
B 24. The rational decision-making process is most often typified by
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a. Perfect information.
b. Bounded rationality.
c. Selection of optimum decisions.
d. Choice of the least risky solution.
B 25. A company has recently introduced total quality management (TQM). The company’s
top management wants to determine a new and innovative approach to foster total
participation throughout the company. Management should
a. Seek isolation from all distractions in order to think the problem through.
b. Bring the employees together for a brainstorming session.
c. Rely on themselves to develop a new approach.
d. Use a disciplined problem-solving approach.
A 26. A highly risk-averse decision maker will often react to bounded rationality by
a. Satisficing.
b. Ignoring the limiting factor.
c. Attempting to find the optimum solution.
d. Increasing the number of solutions considered.
A 27. If Company C has a higher rate of return on assets than Company D, this could be
because Company C has a <List C> profit margin on sales, or a <List D> asset-
turnover ratio, or both.
List List
C D
a High Hig
. er her
b High Low
. er er
c Low Hig
. er her
d Low Low
. er er
Questions 28 and 29 are based on the following information.
A company has ordinary and preference shares outstanding with the following
characteristics:
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Ordinary Shares Preference
Shares
Number of shares 50,000 25,000
outstanding
Dividends paid during the P100,000 P50,000
year
Year-end market price per P10 P5
share
Book value of equity P500,000 P250,000
For the year just ended, the company had the following statement of income:
Sales revenue P1,000,0

00
Cost of goods sold 300,000
Depreciation expense 100.000
Earnings before interest and tax P600,000
Interest expense 100.000
Earnings before tax P500,000
Tax expense 250.000
Net income P250.000
C 28. The company has earnings per share of
a. P2.67
b. P3.33
c. P4.00
d. P5.00
C 29. The company has a rate of return on ordinary equity of
a. 26.67%
b. 33.33%
c. 40.00%
d. 50.00%
B 30. Presented below are partial year-end financial statement data for companies X and
Y.
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Company Company
X Y
Cash P100 P200
Accounts receivable unknown 100
Inventories unknown 100
Net fixed assets 200 100
Accounts payable 100 50
Long-term debt 200 50
Ordinary shares 100 200
Retained earnings 150 100
Company Company
X Y
Sales P600 P5,80
0
Cost of goods sold 300 5,000
Administrative expenses 100 500
Depreciation expense 100 100
Interest expense 20 10
Income tax expense 40 95
Net income 40 95
The degree of financial leverage of Company Y, to two decimal places, is
a. 1.03.
b. 1.05.
c. 1.12.
d. 1.25.
The market price of Fauna Corporation’s ordinary shares is PI 00 per share, and each share
gives its owner one subscription right. Five rights are required to purchase an additional
ordinary share at the subscription price of P91 per share.
A 31. If the ordinary share is currently selling “rights-on,” the value of a right is closest to, in
theory,
a. PI.50.
b. PI.80.
c. P2.25.
d. P9.00.
C 32. The value of one share of Fauna’s ordinary share when it goes “ex-rights,” in theory,
is closest to
a. P91.00.
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b. P98.20.
c. P98 50.
d. P100.00.
D 33. Malibu Inc.’s PI,000 par value preference share paid its P100 per share annual
dividend on April 4 of the current year. The preference share’s current market price is
P960 a share on the date of the
dividend distribution. Malibu’s marginal tax rate is 40%, and the firm plans to maintain
its current capital structure relationship. The component cost of preference share to
Malibu would be closest to
a. 6%.
b. 6.25%.
c. 10%.
d. 10.4%.
The equity section of Smurf Corporation’s Statement of Financial Position is presented below.
Preference share, P100 par P12,000,000

Ordinary share, P5 10,000,000
Paid in capital in excess of par 18,000,000
Retained earnings 9,000,000
Net worth P49,000,000
A 34. The book value of Smurf Corporation’s ordinary share is
a. PI 8.50.
b. P5.00.
c. P14.00.
d. P100.00.
C 35. The ordinary shareholders of Smurf Corporation have preemptive rights. If Smurf
Corporation issues 400,000 additional ordinary shares at P6 per share, a current
holder of 20,000 ordinary shares of Smurf Corporation must be given the option to
buy
a. 1,000 additional shares.

b. 3,774 additional shares.
c. 4,000 additional shares.
d. 3,333 additional shares.
C 36. The market price of Mandalay Corporation’s ordinary shares is P120 per share, and
each share gives the owner one subscription right. Four rights are required to
purchase an additional ordinary share at the subscription price of PI08 per share. If
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the ordinary share is currently selling “rights-on,” the theoretical value of a right is
P2.40. The value of one ordinary share when it goes “ex-rights” should, in theory, be
a. P108.00.
b. P110.40.
c. P117.60.
d. P120.00.
A 37. The market value of a share of stock is P50, and the market value of one right prior
to the ex-rights date is P2.00 after the offering is announced but while the stock is
still selling rights-on. The offer to the shareholder is that it will take three rights to buy
an additional share of stock at a subscription price of P40 per share. If the theoretical
value of the stock when it goes ex-rights is P47.50, the shareholder
a. Does not receive any additional benefit from a rights offering.

b. Receives an additional benefit from a rights offering.
c. Merely receives a return of capital.
d. Should redeem the right and purchase the stock before the ex-rights date.
A 38. The market price of India Corporation’s ordinary share is P30 per share, and each
share gives its owner one subscription right. Four rights are required to purchase an
additional ordinary share at the subscription price of P27 per share. If the ordinary
share is currently selling “rights-on,” the theoretical value of a right is
a. P0.60.
b. P0.75.
c. PI.00.
d. P3.00.
A company’s stock trades rights-on for P50.00 and ex-rights for P48.00. The subscription price
for rights holders is P40.00, and four rights are required to purchase one share of stock.
D 39. The value of a right while the stock is still trading rights-on is
a. P0.40.
b. P0.50.
c. PI.60.
d. P2.00.
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C 40. The value of a right when the stock is trading ex-rights is
a. P0.40.
b. P0.50.
c. P2.00.
d. P2.50.
C 41. Google Corporation’s P 1,000 par value convertible debentures are selling at P1, 040
when its stock is selling for P46.00 per share. If the conversion ratio is 20, what will
be the conversion price?
a. P22.61
b. P46.00
c. P50.00
d. P52.00
A 42. On January 1 of the current year, Bingo Company issued convertible bonds with PI ,
000 par value and a conversion ratio of 50. Which of the following should be the
market price per share of the company’s ordinary share on January 1?
a. Under P20
b. P20
c. Between P20 and P50
d. Above P50
The Darling Corporation projects the following for the year.
Earnings before interest and taxes P35

million
Interest expense P 5
million
Preference share dividends P 4
million
Ordinary share dividend payout ratio 30%
Ordinary shares outstanding 2
million
Effective corporate income tax rate 40%
D 43. The expected ordinary dividend per share for Darling Corporation is
a. P2.34.
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b. P2.70.
c. PI.80.
d. P2.10.
B 44. If Darling Corporation’s ordinary share is expected to trade at a price-earnings ratio

of eight, the market price per share (to the nearest peso) would be
a. P104.
b. P56.
c. P72,
d. P68.
C 45. If a P1, 000 bond sells for PI, 125, which of the following statements are correct?
I. The market rate of interest is greater than the coupon rate

on the bond. II. The coupon rate on the bond is greater than
the market rate of interest.
III. The coupon rate and the market rate are equal.
IV. The bond sells at a premium. V. The bond sells
at a discount.
a. I and IV.
b. I and V.
c. II and IV.
d. II and V.
III. Problems
Problem 1
The Cam Furniture Company is considering the introduction of a new product line. Plant and
inventory expansion equal to 50% of present asset levels will be necessary to handle the
anticipated volume of the new product line. New capital will have to be obtained to finance the
asset expansion. Two proposals have been developed to provide the added capital.
The company’s most recent financial statements are presented herewith.
Cam Furniture Company

Statement of Financial Position
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As of December 31, 2010
Assets Equities
The
Current P 65,000 Debt 5% P
40,000
Plant and 135,000 Ordinary shares 100,00
equipment 0
Retained earnings 60.000
P200,000 P200,0
00
Statement of Comprehensive Income
For the Year Ended December 31, 2010
Sales P600,000
Operating costs 538.000
Operating income 62,000
Interest charges 2.000
Net income before taxes 60,000
Income taxes 30.000
Net income P 30.000
investment banker believes that the stock can be issued to yield P33-1/3. The price-earnings
ratio would remain at 12 to 1 if the stock were issued. The present market price is P36.
REQUIRED:
a. The Vice-President of Finance asks you to calculate the earnings per share and the
market value of the stock (assuming the price-earnings ratios given are valid
estimates) for the two proposals assuming total sales (including the new product line)
of:
1. P400,000 2. P600,000 3. P800,000
Costs exclusive of interests and taxes are about 90% of sales.
 Under the first proposal (debt financing), Cam Furniture Company is required to
issue long term debt amounting to P100,000 (this amount is 50% of present level
assets, and the additional capital needed for plant and inventory expansion.
 Under the second proposal (equity financing), Cam Furniture Company is required
to issue shares the will yield a total amount of P100,000. Since the investment
banker believes that company will yield P 33 1/3 for every share that will be
issued, the company shall issue 3,000 shares (P100,000/ P33 1/3 per share)
Assuming total sales of P400,000

Debt Financing Equity Financing
Sales 400,000 400,000
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Operating Costs (360,000) (360,000)

Operating Income 40,000 40,000
Interest Charges (7,000) (2,000)
Net income before taxes 33,000 38,000
Less: Taxes (50%) (16,500) (19,000)
Net Income 16,500 19,000
Earnings per Share

Debt Financing cannot be determined
Equity Financing
(19,000/ 13,000 shs) P1.46
Market Value of the stock
Equity Financing
(P1.46 * 12 times) P17.52
Assuming total sales of 600,000

Sales 600,000 600,000
Less: Taxes (50%) (26,500) (29,000)
Net Income 26,500 29,000
Earnings per Share

Equity Financing
(29,000/ 13,000 shs) P2.23
Equity Financing
(P2.23* 12 times) P26.76
Assuming total sales of P800,000
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Sales 800,000 800,000
Less: Taxes (50%) (36,500) (39,000)
Net Income 36,500 39,000
Earnings per Share

Equity Financing
(39,000/ 13,000 shs) P3.00
Equity Financing
(P3.00 * 12 times) P36.00
Notes/ Explanations:
 The total interest charges under debt financing is 7,000
o (40,000 * 5%) + (100,000 * 5%) = P7,000
 The total number of shares outstanding under equity financing is 13,000
shares (10,000 shares + additional 3,000 shares)
 The students believe that the there is a missing information with regards
to the P/E ratio of proposal for debt financing. The PE ratio of 12 to 1
cannot be used for debt financing because the problem provides that PE
ratio would remain at 12 to 1 if only the additional stocks were issued.
Computation for the number shares outstanding before issuance of
additional shares (in view of choosing the proposal of equity financing)
P/E Ratio = share price/ earnings per share
EPS = share price/ PE Ratio
= P36/ 12 times
= P3.00
No. of = Net Income/ EPS
Shares outstanding
= P30,000 / P3.00
= 10,000 shares
 The formula for earnings per share is:
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EPS=Net Income /Number of Ordinary Shares Outstanding
 The formula for market value of the stock is
MV of the stock=EPS∗PE Ratio
b. Which proposal would you recommend? Your answer should indicate:
1. the criteria used to judge the alternatives.
Proposal 1: Issuance of Proposal 2: Issuance of

Criteria
debt shares
None (less vulnerable to
decline in sales and
Possible liquidity problems Present
earnings; company is not
obligated to pay dividends)
Present (there are fixed
interest payments
Increased bankruptcy risk None
regardless of company’s
economic position)
May depress the market
Credit rating is enhanced
value of company’s
Effect of proposal on the or maintained; higher
outstanding ordinary
image of the company credit rating enhances
shares if used beyond a
stock value
given point
2. a brief defense of the criteria used.
Cam Furniture Company is considering a plant and inventory expansion amounting to

100,000 (equal to 50% of its present asset level which is significant) to handle the
anticipated volume of a new product line. Since the company’s product is new to the
market, the sales growth during its early years is not guaranteed to be steady and high
enough to be able to pay the fixed interest and principal payments when a large debt
is to be issued. Hence, the criteria of liquidity problems and bankruptcy risk is
created. In addition, Cam Furniture Company is currently expanding its business so it
is necessary to maintain a good credit standing to enhance the value of its stock,
hence, the last criteria is created.
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3. the proposal chosen in accordance with the criteria.
The Proposal 2 or the issuance of shares is chosen because the bankruptcy risk and
possible liquidity problems of the company which is currently undergoing through an
expansion is minimized. Moreover, the company is not obligated to pay fixed payments
but rather pay dividends whenever the sales of the company is already stable. Lastly, the
credit rating of the company is maintained by issuing equity, thus making it easier for the
company to obtain loans in the future for further expansion (when expansion guarantee
high and steady revenue).
c. Would your answer to B change if a sales level of P1, 200,000 or more could be
achieved? Explain.
No. The higher level of sales won’t affect the criteria mentioned above. Even if the sales
level increased, possible liquidity problems and bankruptcy risk will still be present if the
company chose to issue debt.
d. What reason(s) would the investment broker give to support the estimate of a lower
price-earnings ratio if debt is issued?
The first step in computing the price-earnings (P/E) ratio is to calculate the earnings per
share (EPS). Typically, EPS is the company’s after tax profits divided by the number of
shares outstanding. From the EPS, we can calculate the P/E ratio by dividing the
company’s current market share price by the earnings per share.
If debt is issued, the company’s EPS would be higher compared to the EPS if shares are
issued because of the corresponding increase in shares outstanding which will be used
as the denominator. Therefore, the company will get a lower P/E ratio because of the
higher EPS used.
Problem 2
Faye Industries Inc., a manufacturer of sporting goods, has a primary manufacturing plant which
is old and located within the limits of a large Midwestern city. Faye has recently obtained land in
a favorable location outside the city with the idea of building a modern, efficient facility to
replace the old manufacturing plant.
Faye Industries had planned to finance the P15, 300,000 cost of the new facility by issuing P1
par value ordinary share with an estimated market value of P2 per share. Alternately, Faye’s
investment banker indicated that the PI 5,300,000 could be raised through the sale of PI00 par
value, 13 percent, non-participating preference share at the market value of P120 per share or
the sale of P15,300,000 of 10 percent long-term bonds at P1,000 par.
Portions of Faye’s financial statements for the fiscal year ended November 30, 2010, are
presented below. The expected income before interest and taxes for the fiscal year ending
November 30, 2011, after building the new facility, is PI2, 978,000. There are no planned
dividend payments to ordinary shareholders for the fiscal year ending November 30, 2011. The
average before-tax cost of the existing long-term debt is 9.5 percent, and the company’s
effective tax rate is 40 percent.
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Faye Industries Inc. .

Consolidated Statement of Comprehensive Income
Fiscal Year Ended November 30,
2010 (P000 omitted)
Revenues:
Net sales ………………………………… P97,5
….. 56
Other income, including license ………………………………… 1,305
fees …..
P98,8
Expenses: 61
Cost of sales …………………………………….. Selling, general P70,078

and administrative expenses …………………………………….. 17,890
Interest expense - net …………………………………….. 1,273
P89.241
Income before provision for income taxes P9,620
3,848
…………………………………….. Provision for income taxes
P5,772
…………………………………….. Net income for the year
P0.22
…………………………………….. Earnings per ordinary share
……………………………………..
Faye Industries Inc.

Liabilities and Equity
November 30, 2010
(P000 omitted)
Current liabilities: P2,127

Short-term notes payable 6,297
Trade accounts payable
Other current liabilities and accrued expenses 1.285
Long-term liabilities: P 9,709
Long-term debt, 9.5 percent P13,395
Capitalized lease obligations 479
Total liabilities P13,874
Equity: P23,583
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Ordinary shares par value P1
(issued and outstanding,
26,330,000 shares) P26,330
Capital in excess of par value 17,269
Retained earnings 11,429
Total equity P55,028
Total liabilities and equity P78,611
REQUIRED:
Assuming that Faye Industries Inc. will achieve the expected earnings from the new
manufacturing facility, and assuming that any new financing will take place on December 1,
2010, compute the pro forma earnings per ordinary share and the estimated return on average
ordinary shareholders’ equity for the fiscal year ending November 30, 2011, if the expansion is
financed by issuing.
1. long-term bonds.
Earnings per Share = Net income after interest and taxes - preference dividends
Average number of ordinary shares outstanding
= P6,105,000 – 0
(26,330,000 + 26,330,000) / 2
= P6,105,000
P26,330,000 shs.
= P 0.23
Return on Ordinary Equity = Net income after interest and taxes - preference
dividends
Average Ordinary Equity
= P6,105,000 – 0
(P 55,028,000 + P 55,028,000) / 2
= P6,105,000
P55,028,000
= 11.09%
Page 20 of 24
Computations
Existing long-term debt (P13,395,000 x 9.5%) P 1,273,000

Long-term bonds (P15,300,000 x 10%) 1,530,000
Interest expense P 2,803,000
Net income before interest and taxes P12,978,000

Less: Interest expense 2,803,000*
Net income before taxes P10,175,000
Less: Taxes (40%) 4,070,000
Net income after taxes P 6,105,000
November 30,2014 No. of ordinary shares issued and outstanding 26,330,000 shares
Total Equity – Preference Equity = Ordinary Equity

November 30, 2014 P55,028,000 – P0 = P 55,028,000
November 30, 2015 P55,028,000 – P0 = 55,028,000
Total = P110,056,000
/2
Ave. Ordinary equity for November 30,2015 P 55,028,000
Explanation
 No Preference dividend has been distributed for the year.
 No change of ordinary shares has been made for the year.
 The earnings per share if the entity choose to expand by issuing long bonds is equal to
the net income after interest and taxes of P6,105,000 divided by the average number of
ordinary shares outstanding of 26,330,000 shares.
 The return on equity is equal net income after interest and taxes of P6,105,000 divided
by average ordinary equity of P 55,028,000.
Page 21 of 24
2. preference shares.
= P7,023,000 – P1,657,500
(26,330,000 + 26,330,000) / 2
= P5,365,500
P26,330,000 shs.
= P 0.20
Return on Ordinary Equity = Net income after interest and taxes - preference dividends
= P7,023,000 – P1,657,500
P55,474,250
= P5,365,500
P55,474,250
= 9.67%

Less: Interest expense 1,273,000
Less: Taxes (40%) 4,682,000
Net income after taxes before preference dividends P 7,023,000
Less: Dividends to preference (P12,750,000 x 13%) 1,657,500
Net Income available to Ordinary shares P5,365,500
Cash received from selling preference share P15,300,000

Divide by: Market Value per share P120
Number of Preference shares 127,500 shs.
Multiply by: Par value per share P100
Par value of Preference shareholder’s equity P12,750,000
Dividends to preference (P12,750,000 x 13%) P 1,657,500
Total Preference shareholder’s equity P14,407,500
Page 22 of 24

November 30, 2014 P55,028,000– P0 = P55,028,000
November 30, 2015 P70,328,000 – P14,407,500 = 55,920,500
(P55,028,000 + 15,300,000)
Total = P110,948,500
/2
Explanation
 No change of ordinary shares has been made for the year.
 The earnings per share when the entity choose to expand by issuing preference shares is
equal to the net income after interest and taxes of P7,023,000 less preference dividends
P1,657,500 divided by the average number of ordinary shares outstanding of
26,330,000.
 The return on equity is equal net income after interest and taxes of 7,023,000 less
preference dividends P1,657,500 divided by average ordinary equity of P55,474,250.
3. ordinary shares.
= P7,023,000 – 0
(26,330,000 + 33,980,000) / 2
= P7,023,000
P30,155,000 shs.
= P 0.23
Return on Ordinary Equity = Net income after interest and taxes - preference dividends
= P7,023,000 – 0
P62,678,000
= P7,023,000
P62,678,000
= 11.20%
Page 23 of 24

Less: Interest expense 1,273,000
Less: Taxes (40%) 4,682,000
Net income after taxes before P 7,023,000
November 30, 2014 No. of ordinary shares issued and outstanding 26,330,000
shares
November 30, 2015 No. of ordinary shares issued and outstanding
New issued shares P15,300,000
Divide by: Market value per share P2
Number of Ordinary shares issued 7,650,000 shs.
Nov. 30, 2014 outstanding shares 26,330,000 shs. 33,980,000
shares
November 30, 2014 P55,028,000– P0 = P55,028,000
November 30, 2015 P70,328,000 – P0 = 70,328,000
(P55,028,000 + 15,300,000)
Total = P125,356,000
/2
Explanation
 No Preference dividend has been distributed for the year.
 The earnings per share when the entity choose to expand by issuing ordinary share the
net income after interest and taxes of P7,023,000 divided by the average number of
ordinary shares outstanding of 33,980,000 shares.
 The return on equity is equal net income after interest and taxes of P7,023,000 divided
by average ordinary equity of P62,678,000.
Page 24 of 24

Module 2 Sources of Intermediate and Long-Term Financing

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Module 2 Sources of Intermediate and Long-Term Financing

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ALDERSGATE COLLEGE FINANCIAL MANAGEMENT 2

SCHOOL OF BUSINESS AND ACCOUNTANCY

1. What are some specific features of bond agreements?

Preference share Subordinated debenture

senior secured debt,

Conversion of bonds to common stock through either a convertible bond or an exchange

4. Discuss the advantages and disadvantages of debt.

The primary advantages of debt are:

The disadvantages are:

D 1. Increases in total long-lived assets should not ordinarily be financed by

a. the allowances for depreciation.

a. Private placements go through a time-consuming process of SEC registration

a. the increased probability of bankruptcy during periods of high interest rates.

a. a non-participating preference share.

E 8. A convertible debenture is used

a. as a sweetener when raising capital by debt instruments.

a. The firm has increased its operating leverage.

C 11. Which of the following statements properly describes an advantage of ordinary

a. Ordinary share is less costly, and liquidity risk is less.

a. private placement rather than a public offering will be made.

a. gives holders of ordinary shares first option to purchase additional ordinary

D 15. A rights offering will probably fail

a. The avoidance of the risk of technological obsolescence.

The following information applies to items 18 to 20.

a. New issues of bond and stock securities.

C 22. The term “underwriting spread” refers to the

a. Commission percentage an investment banker receives for underwriting a

B 24. The rational decision-making process is most often typified by

Questions 28 and 29 are based on the following information.

Sales revenue P1,000,0

C 28. The company has earnings per share of

C 29. The company has a rate of return on ordinary equity of

The degree of financial leverage of Company Y, to two decimal places, is

Questions 31 and 32 are based on the following information.

Questions 34 and 35 are based on the following information.

Preference share, P100 par P12,000,000

A 34. The book value of Smurf Corporation’s ordinary share is

a. 1,000 additional shares.

a. Does not receive any additional benefit from a rights offering.

Questions 39 and 40 are based on the following information.

C 40. The value of a right when the stock is trading ex-rights is

Questions 43 and 44 are based on the following information.

The Darling Corporation projects the following for the year.

Earnings before interest and taxes P35

B 44. If Darling Corporation’s ordinary share is expected to trade at a price-earnings ratio

I. The market rate of interest is greater than the coupon rate

The company’s most recent financial statements are presented herewith.

Cam Furniture Company

1. P400,000 2. P600,000 3. P800,000

Costs exclusive of interests and taxes are about 90% of sales.

Assuming total sales of P400,000

Operating Costs (360,000) (360,000)

Earnings per Share

Assuming total sales of 600,000

Earnings per Share

Assuming total sales of P800,000

Debt Financing Equity Financing

Earnings per Share

 The formula for earnings per share is:

 The formula for market value of the stock is

MV of the stock=EPS∗PE Ratio

b. Which proposal would you recommend? Your answer should indicate:

1. the criteria used to judge the alternatives.

Proposal 1: Issuance of Proposal 2: Issuance of