Capital Structure and Long-Term Financing Decision

1. Factors to consider in planning the methods of financing

• Consider Repayment Terms- consider how long the financing arrangement is
structured to last.
• Cost of Finance/interest and fee structure- add up all the cost associated with
each financing method and its effect on income
• Risk- consider what will happen if we are unable to meet the financing
commitments relating to that particular source of finance
• Control- issuing additional shares (equity) will result in a dilution of control among
existing shareholders

2. Characteristics of debt versus equity

Advantages
Debt
➢ Formal legal contract
➢ Fixed maturity date
➢ Fixed periodic interest payments
➢ Security in case of default
➢ No direct voice in management:
influence through debt covenants
➢ Interest is an expense
Equity
➢ No legal contract
➢ No fixed maturity dates
➢ Discretionary dividend payments
➢ Residual asset interest
➢ Vote for board of directors
➢ Dividends are not expense but a
distribution of retained earnings

3. Cost of Capital – refers to the opportunity cost of making a specific investment. It is the
rate of return that could have been earned by putting the same money into different
investment with equal risk.

Example: Let’s assume Company XYZ is considering whether to renovate its

warehouse systems. The renovation will cost $50 million and is expected to save $10 million per
year over the next 5 years. There is some risk that the renovation will not save company XYZ a
full $10 million a year. Alternatively, company XYZ could use the $50 million to buy equally risky
5-year bonds in ABC Co., which return 12% per year
Because the renovation is expected to return 20% per year ($10 million/$50
million), the renovation is a good use of capital, because the 20% return exceeds the 12%
required return XYZ could gave gotten by taking the same risk elsewhere.
 4. Dividend Policy – refers to the policy that the management formulates in regard to
earnings for distribution as dividend among shareholders. Dividend policy provides as a
base for all capital budgeting activities and in designing a company’s capital structure.
*Dividend-return declared to the equity shareholders through the distribution of
a portion of profits earned by the organization

Factors affecting Dividend Policy

a. Funds Liquidity i. Company’s financial policy
b. Past Dividend rates j. Impact of trade cycle
c. Earnings Stability k. Borrowings ability
d. Debt Obligations l. Legal restrictions
e. Investment opportunities m. Corporate taxation policy
f. Control policy n. Government policy
g. Shareholders’ expectation o. Divisible profit
h. Nature and size of
organization

Types of Dividend Policy

a. Stable Dividend Policy- Company decides a fixed amount of dividend for the
shareholders, which is paid periodically. There is no change in the dividend allowed
even if the company incurs loss or generates high profit.
b. Regular Dividend Policy- certain percentage of the company’s profit is allowed as
dividends for the shareholders. When the gain is high, the shareholders’ earnings will
also hike and vice-versa.
c. Irregular Dividend Policy- the company may or may not pay dividends to the
shareholders. The top management solely take all dividend decisions, as per their
priorities.
d. No Dividend Policy- Company always retains the profits to further projects. No
intention of declaring any dividends to its shareholders

5. Long-term Financing
• Long-term Financing Decisions- primarily aimed in determining the best mix of
the permanent sources of funds used by a firm in a manner that will achieve the
optimal capital structure
• Capital Structure- refers to the mix of the long-term sources of funds used by the
firm. It is composed of long-term debt, preferred stock and common stockholders’
equity.
 • Capital Market- venues where savings and investments are channeled between
the suppliers who have capital and those who are in need of capital. Place where
various entities trade different financial instruments.
• Obtaining funds from the capital market
- Capital market consist of the primary market, where new securities are issued
and sold, and the secondary market, where already-issued securities are
traded between investors. Most common capital markets are the stock market
and bond market.
• Debt (Bond) Financing- occurs when a firm raises money for working capital or
capital expenditures by selling debt instruments to individuals and/or institutional
investors. In return for lending the money, the individuals or institutions become
creditors and receive a promise that the principal and interest on the debt will be
repaid.
Basic Types of Bonds or Long-term Debt
a. Debenture Bonds- unsecured loan; issued by companies with good credit
ratings
b. Mortgage Bonds- secured loan with pledge of certain assets, such as real
property.
c. Income Bonds- pay interest only if the issuing company has earnings.
d. Serial Bonds- bonds with staggered maturities
e. Floating Bonds- bonds with varying interest rates.

• Equity Financing- process of raising capital through the sale of shares. In return
for the investment, the shareholders receive ownership interests in the company.

Advantages
Debt Equity
➢ Keep full ownership ➢ Less risk than debt
➢ No obligations after paying debt ➢ No paying back funds
➢ Interest is tax deductible ➢ Gain credibility through investor
➢ Short and long-term options networks
➢ More cash on hand ➢ Investors don’t expect immediate
ROI
➢ Fixed payments for better
budgeting
Disadvantages
Debt Equity
➢ Must pay back ➢ Investor returns could be more
➢ Could cause cash flow issues than debt payments
➢ Usually need collateral ➢ Investor gets some ownership
 ➢ Must consult investor for decisions

• Lease Financing
*Lease- a rental agreement that typically requires a series of fixed payments that
extend over several periods.
*Lease vs Borrowing- leasing represents an alternative to borrowing, the lease payments are very
similar to loan amortization, with part of payment applied to principal and part to interest. Like
loan agreements, lease contracts usually contain restrictive covenants like the requirement to
maintain minimum debt-equity ratios of minimum level of liquid assets. Basic difference:
ownership of asset.

Leasing Benefits
➢ Increased flexibility- lease can be cancelled or replaced with a new one depending on the
need of the firm
➢ Tax Savings- the tax shield generated by lease payments usually exceeds that from
depreciation if the asset were purchased
Types of leases:
➢ Operating Lease- usually a short-term and often cancelable; obligation is not shown on
the balance sheet, maintenance and upkeep of asset is usually provided by the lessor;
leases payment is treated as rent expense
➢ Capital or Financial Lease- non-cancelable; long-term lease that fully amortizes the
lessor’s cost of the asset; service and maintenance are usually provided by the lessee
➢ Sales and Leaseback- assets that are already owned by a firm are purchased by the lessor
and are subsequently leased back to the firm.

Group 4:
Aguite, Laverne Padre, Josenico
Arellano, Zaira Pitpit, Julius
Jacinto, Neil Justine Salcedo, Limuel
Macatumbas, Nicholette Alecs Santiago, Dan Cyrelle

Manding, Rhoi Kenneth