LONG TERM FINANCING DECISIONS

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 fund used by the firm. It is composed of long-term debt,
preferred stock and common stockholders' equity

FINANCIAL STRUCTURE
refers to the mix of all firm's assets

CAPITAL STRUCTURE = FINANCIAL STRUCTURE (Total Assets) - Current Liabilities

OPTIMAL CAPITAL STRUCTURE

refers to the mix of long term sources of funds that will minimize the firm's over-all cost of capital,
at which the stock price is at maximum

OBJECTIVE: To maximize the market value of the firm through an optimal mix of long-term
sources of funds.

CAPITAL REQUIREMENTS: ADDITIONAL FUNDS NEEDED (AFN)

FM reuirs through analysis of the firm's capital reuirements. Generally, the additional (external0
funds needed' can be determined by using the following formula:

Required increase in assets in Sales x (Assets/Sales)

- Spontaneous increase in Liab in Sales x (Liability/Sales)
- Increase in Retained Earnings Earnings after Tax - Dividend Payment
ADDITIONAL FUNDS NEEDED

*Alternative Computation: Increase in retained earnings = (Expected Sales x Profit Margin) x

Retention ratio

FACTORS INFLUENCING LONG-TERM DINANCING DECISIONS

Ø    BUSINESS RISK
uncertainty inherent in projections of future returns on assets. The greater the business risk, the
less debt should be included in its capital structure

Ø    TAX POSITION
generally, the higher the firm's tax rate, the more debt it should include in its capital structure,
Reason: interest expense is tax deductible

Ø    FINANCIAL FLEXIBILITY
the firm's ability to raise capital on reasonable terms even under adverse conditions

Ø    MANAGERIAL AGRESSIVENESS
refers to some financial managers' inclination to use more debt to boost profit

EXERCISES:
1 ADDITIONAL FUNDS NEEDED
SPAIN Corporation's sales are expected to increase from P 5,000,000 in 2012 to P 6,000,000 in 2012.
Its assets totaled to P 3,000,000 at the end of 2012. Spain has full capacity, so its assets must grow in
proportion to projected sales. At the end of 2012, current liabilities are P 1,000,000, ( P 200,000 of AP,
P 500,000 of notes payable and P 300,000 of accruals). The after tax profit margin is projected to be
10%. The forecasted payout ratio is 75%.
 1 ADDITIONAL FUNDS NEEDED
REQUIRED: Determine the additional funds needed from external sources

v    Key financial ratios:

ü Capital intensity ratio = Assets / Sales
ü After-tax profit margin = After-tax profit / Sales
ü Dividend pay-out ratio = Dividends/Earnings = Dividend per share / Earnings per share
ü Retention ratio = 100% - Dividend payout ratio

2 TARGETED CAPITAL STRUCTURE

Omega Company has the following capital structure
Debt, (16%) 750,000,000
Preferential share, (12.5%m P 100 par) 300,000,000
Ordinary share, (P 10 par) 1,000,000,000
Retained earnings 450,000,000
Total 2,500,000,000

Omega Company considers the following options for the financing of its planned expansion that
requires additional external financing for P 300,000,000

OPTION A
60% borrowing at 18%
The balance through the issuance of ordinary shares at P 15 per share

OPTION B
20% borrowing at 18%
15% preferential share at 12.5% to be issued at par
65% ordinary share to be sold at P 15 per share

Corporate tax rate is 35%

The project is likely to generate earnings before interest and taxes of P 230,000,000

REQUIRED: Between option A and B, which option shall be selected to achieve the higher EPS?

OPTION A OPTION B
 SOURCES OF INTERMIEDIATE & LONG TERM FINANCING

1. INTERNAL Sources
·        Operations
  (Retained Earnings)
Earnings available after the payment of interest, taxes and preferred stock dividends may
be used to either pay common, cash dividends or be plowed back into the company in the
form of additional investment

Advantages of internal financing:

1. The after-tax opportunity cost is lower than that for newly issued common stock
2. Financing with retained earnings leaves the present control intact

2. EXTERNAL Sources
·        Debt
  (Bonds) Financing
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
  (Common) Financing
The sale of common stock is frequently more attrative to investors than debt, because it
grows in value with the success of the firm. The higher the common stock value, the more
advantageous euity financing is over debt financing

·        Hybrid
  Financing
These are sources o funds that possess a combination of features' these include
preferred stock, leasing, and option securities such as warrants and convertibles

Ø    PREFERRED STOCK a hybrid security because some of its characteristics are similar to those
of both common stock and bonds. Legally, like common stock, it represents a part of
ownership or euity in a firm. However, as in bonds, it has only a limited claim on a
firm's earnings and assets

Ø    LEASE FINANCING
LEASE a rental agreement that typically reuires a series of fixed payments that extend over
several periods

LEASING 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 reuire-
ment to maintain minimum debt-equity ratios of minimum level of liquid assets.
BASIC DIFFERENCE: OWNERSHIP of the ASSET

LEASING BENEFITS
ü Increased Flexibility - in some cases, lease can be cancelled or replaced with a new one,
depending on the need of the firm

ü Tax Savings - the tax shield generated by lease payments usually exceeds that from
depreciation if the asset were purchased

TYPES OF LEASES:
1. OPERATING LEASE - usually short-term and often cancelable; obligation is not shown
on the balance sheet, maintenance and upkeep of asset is usually porovided
by the lessor; lease payment is treated as rent expense

2. 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

3. SALES AND LEASEBACK - assets that are already owned by a firm are purchased by the
lessor and are subsequently leased back to the firm

Ø    CONVERTIBLE SECURITIES
preferred stock or bond issue that can be exchange for a specified number of shares of
common stock at the will of the owner. These are generally considered hybrid securities
because they provide the stable income associated with preferred stock and bonds in
addition to the possibility of capital gains associated with common stocks

Ø    WARRANT - an option granted by the corporation to purchase a specified number of shares of

common stock at a stated price exercisable until some time in the future called the
expiration date. Usually, it is attached to debt instruments as n incentive for investors
to buy the combined issue at a lower interest rate
Ø    OPTION - it is a contract that gives its holders the right to buy (or sell) stocks at some predeter-
mined price (usually less than stock's market prices) within a specified period of time.
 LONG TERM FINANCING DECISIONS

1 ADDITIONAL FUNDS NEEDED

SPAIN Corporation's sales are expected to increase from P 5,000,000 in 2012 to P 6,000,000 in 2012.
Its assets totaled to P 3,000,000 at the end of 2012. Spain has full capacity, so its assets must grow in
proportion to projected sales. At the end of 2012, current liabilities are P 1,000,000, ( P 200,000 of AP,
P 500,000 of notes payable and P 300,000 of accruals). The after tax profit margin is projected to be
10%. The forecasted payout ratio is 75%.

REQUIRED: Determine the additional funds needed from external sources

1 Required increase in assets Δin sales x Assets/Sales
= 3M x 1M 1,000,000
5M OR 5,000,000 = 20% x 3M = 600,000

2 Spontaneous increase in Liab Δin sales x Liab/Sales

= 200 + 300 x 1M OR 300,000+200,000 500,000 0.1
5M 5,000,000 = 5,000,000 x 1,000,000 = 100,000

3 Increase in retained earnings Earnings after tax-Div payment =

= 6,000,000 x 10% = 600,000 x 25% = 150,000

v    Key financial ratios:

ü Capital intensity ratio = Assets / Sales
ü After-tax profit margin = After-tax profit / Sales
ü Dividend pay-out ratio = Dividends/Earnings = Dividend per share / Earnings per share
ü Retention ratio = 100% - Dividend payout ratio

THEREFORE:

Required increase in assets = 1,000,000 X 3/5 600,000

- Spontaneous increase in liabiities = 1,000,000 X 0.25/5 100,000
- Increase in retained earnings = 6,000,000 X 10% X 25% 150,000 250,000
ADDITIONAL FUNDS NEEDED 350,000

2 TARGETED CAPITAL STRUCTURE

Omega Company has the following capital structure
Debt, (16%) 750,000,000
Preferential share, (12.5%m P 100 par) 300,000,000
Ordinary share, (P 10 par) 1,000,000,000
Retained earnings 450,000,000
Total 2,500,000,000

Omega Company considers the following options for the financing of its planned expansion that
requires additional external financing for P 300,000,000

OPTION A
60% borrowing at 18%
The balance through the issuance of ordinary shares at P 15 per share

OPTION B
20% borrowing at 18%
15% preferential share at 12.5% to be issued at par
65% ordinary share to be sold at P 15 per share

Corporate tax rate is 35%

The project is likely to generate earnings before interest and taxes of P 230,000,000

REQUIRED: Between option A and B, which option shall be selected to achieve the higher EPS?
SOLUTIONS:
OPTION A OPTION B
Earnings BEFORE interest and tax 230,000,000 230,000,000
Less: Int expense 750M x 16% 120,000,000
180M x 18% 32,400,000 152,400,000

750M x 16% 120,000,000

60M x 18% 10,800,000 130,800,000

Income before taxes 77,600,000 99,200,000

Less: Income tax 35% 27,160,000 34,720,000

Net income before dividends 50,440,000 64,480,000

Less: Preferential dividends
 Option A 300M X 12.5% 37,500,000
Option B 45M X 12.5% 5,625,000 43,125,000

Income to Ordinary shareholders 12,940,000 21,355,000

No. of ordinary shares
Option A Current 100,000,000
8,000,000 108,000,000

Option B Current 100,000,000

13,000,000 113,000,000

EPS 11.98% 18.90%

Current Fixed Financing Charges:

·         Annual interest = 750,000,000 (16%) = 120,000,000
·         P/S Dividends = 300,000,000 (12.5%) = 37,500,000

Option A
·         Debt (60%) = 180,000,000 (18%) = 32,400,000*
·         Common stock (40%) = 120,000,000/15 (per share) = 8,000,000 shares

Option B
·         Debt (20%) = 60,000,000 (18%) = 10,800,000 **
·         Common stock (65%) = 195,000,000/15 (per share) = 13,000,000 shares
·         Preferred stock (15%) = 45,000,000 (12.5%) = 5,625,000***