Assessing Long-Term Debt, Equity and Capital Structure

St.
Anthony’s College
Amare et Servere AEC 213 Financial Management
ASSESSING LONG-
TERM DEBT, EQUITY
& CAPITAL
STRUCTURE
St. Anthony’s College
Traditional
Approach
Capital
Structure
Theory
Modigliani &
Contemporary
Miller
Approach
Approach
Traditional Approach
• A firm can lower its weighted average cost of
capital and increase its market value by the
judicious use of financial leverage
• There is a trade-off between cheaper debt and
higher priced equity that leads to an optimal
capital structure
Market Market Value of

Value of Common Shares
Value of
the Firm Outstanding or
Debt Equity
EBIT (1 – T)
Value of the
Firm
Weighted Average Cost
of Capital
Modigaliani & Miller Approach I

• Also called as Perfect World Approach
• A firm’s value is determined by its real assets,
not by securities it issues
• Assumes no taxes, no chance of bankruptcy, and
no brokerage costs investors can borrow at the
same rate as corporations
Modigaliani & Miller Approach II

• Shows that the use of financial leverage lowers
a firm’s cist of capital and raises the firm’s value
because interest on debt is tax deductible
EBIT (1 – T)
Value of an
Unlevered Firm
with Corporate
taxes Cost of Equity of an
Unlevered Firm
Value of a Value of the

Levered Firm Present Value of
with Corporate Unlevered the Interest tax
taxes Firm shield
Contemporary Approach
• Also called as the Trade-off theory
• There is a optimal capital structure or at least
an optimal range of structures for every firm
• It identifies several factors that can lead to
optimal capital structure
Value of a Levered
Value of the Present Value of
Firm with Taxes, Present Value of
the Financial
Financial Distress Levered Firm the Net Tax
Distress and
and Related Costs with taxes Savings
Related Costs
SOURCES OF LONG-
TERM FINANCING
Internal Operations
Sources
Sources
External Debt
Equity
Sources Hybrid Financing

Debt Financing
• It includes loans from friends and relatives as
well as external capital from banks or venture
capitalists
Bonds
• Any long-term promissory note issued by the
firm
• A bond certificate is the tangible evidence of
debt issued by a corporation or a governmental
body and represents a loan made by investors
to the issuers
Unsecured loan; these can be issued

Debenture only by companies with the best credit
Bonds ratings
Bonds with staggered

maturities
Types A pledge of certain assets,
Serial Mortgage
Bonds of Bonds
such as real property, for a
Bonds loan
Pay interest only if the issuing company

has earnings; these bonds are riskier Income
that other bonds Bonds
Equity Financing
• It includes common stocks and retained
earnings
Hybrid Financing
• It includes funds that possess a combination of
features; these include preferred stock, leasing
and option securities such as warrants and
convertibles
Preferred
Stock
Lease
Financing Warrant
Convertible
Option
Securities
Preferred Stock
• It is a hybrid security because some of its
characteristics are similar to those of both
common stocks and bonds.
• Legally, it represents a part of ownership or
equity in a firm
Lease Financing
• It represents an alternative to borrowing
Type of Lease Characteristics

• Usually short-term
• Often cancelable
Operating • Obligation is not shown on the
balance sheet
• Maintenance and upkeep of asset
Lease is provided by the lessor
• Lease payment is treated as rent
expense

• Usually long-term
• Non-cancelable
Financial or • Fully amortizes the lessor’s cost of
the asset
• Service and maintenance are
Capital Lease usually provided by the lessee

• Assets that are already owned by
Sale- the firm are purchased by a lessor
and leased back to the firm
Leaseback
Arrangement

• Identical to the sale-leaseback
arrangement, except that the
lessee does not necessarily own
Direct Leases the leased asset

• The lessor already owns or acquires
the asset, which is then provided to
the lessee

• A special lease arrangement under
which the lessor borrows a
Leveraged substantial portion of the
acquisition cost of the leased asset
from a third party
Leases
Convertible Securities
• Preferred stock or debt issue that can be exchanged
for a specified number of shares of common stock at
the will of the owner. These are considered hybrid
securities because they provide the stable income
associated with preferred stock and bonds in
addition to the possibility of capital gains associated
Options
• Created by outsiders rather than the firm itself, it is a
contract that gives its holders the right to buy (or
sell) stocks at some predetermined price within a
specified period of time
Warrant
• An option granted by the corporation to purchase a
specified number of shares of common stock at a
stated price exercisable until sometime in the future
called the expiration date. It is a company-issued call
option. Often it is attached to debt instruments as an
incentive for investors to buy the combined issue at
a lower interest rate
Number 1
Which of the following is not a source of long-
term financing?
a. Common stocks c. Preferred stocks

b. Bonds d. Floating Lien
Number 2
Which of the following brings in additional
capital to the firm?
a. Issuance of stock dividend

b. Two-for-one stock split
c. Exercise of warrants
d. Conversion of convertible bonds to common stocks
Number 3
To acquire additional capital while attempting
to maximize EPS, a company should normally
a. Select debt over equity initially
b. Select equity over debt initially
c. Issue both bonds and stocks in equal proportion
d. Discontinue paying dividends & use current cash flows to
raise capital funds
Number 4
Oneng Corporation’s present capital structure consists of 30%
debt, 10% preferred equity, and 60% common equity. This
capital structure is considered optimal and Oneng Corp. wishes
to maintain it. For the coming year, Oneng Corp. is planning to
invest in an P80M project that will be financed according to
the desired capital structure. Currently, Oneng Corp. has P20M
cash available for the project.
Number 4
Requirement:
I. Compute the percentage of P80M that will come from long-term
debt
II. Compute the percentage of P80M that will come from a new
issuance of common stock
III. If the company will maintain the optimal capital structure to finance
the project, and preferred stocks are issued, the proceeds should be
___________________.
CAPITAL BUDGETING
Capital Budgeting
• It is the process of identifying, evaluating, planning,
and financing capital investment projects of an
organization.
Capital Budgeting Decisions
Financing Decision Investment Decision

• Judgment regarding the method • Judgment about which assets to
of raising capital to fund an acquire to achieve the
investment company’s stated objectives
4
1 Selection
(choosing the investment
Identification and projects after evaluating their
Stages in
projected costs and benefits)
definition
the Capital 2 5
Budgeting
Search for potential
investment projects Financing
Process 3
6
Information gathering
Implementation and
(bot quantitative & monitoring
qualitative information)
Replacement
Types of
Capital
Investment
Projects
Expansion Improvement
Screening and
Selecting Capital
Investment
Proposals
Commonly used methods of evaluating capital

investment projects
Discounted Cash Flow Non-discounted Cash Flow
Approach (Time-Adjusted) Approach (Unadjusted)
• Net Present Value Method • Payback Period
• Internal Rate of Return • Bail-out Period
• Profitability Index • Payback Reciprocal
• Discounted Payback Period • Accounting Rate of Return
Net Present Value

• It is the excess of the present value of a
project’s cash inflows over the amount of
the initial investment
Net Present Value

Present value of cash inflows
(Present value of cash outflows)
Net Present Value
Net Present Value

(Present value of cost of investment)
Net Present Value
Net Present Value

(Cost of investment)
Net Present Value
Decision Rule – NPV
Accept Project
if Calculated
NPV
≥ 0
Reject Project if
Calculated NPV < 0
Internal Rate of Return

• Also known as discounted rate of return
and time-adjusted rate of return is the rate
which equates the present value of the
future cash inflows with the cost of
investment which produces them
Net cost of investment

PVF For
Internal Rate of
Return
Net cash inflows

Decision Rule – IRR
Accept Project Cost of

if Calculated
IRR
> Capital
Cost of
Reject Project if
Calculated IRR < Capital
Profitability Index
• Also known as benefit/cost ratio present value
desirability index
• It expresses the present value of cash benefits
as to an amount per peso of investment in a
project and is used as means of ranking
projects in a descending order of desirability
Total present value of

cash inflows
Profitability
Index
cash outflows

cash inflows
Profitability
Index
Cost of Investment
Net Present Value

Net Present
Value Index
Investment
Decision Rule – PI
Accept Project
if Calculated PI ≥ 1
Reject Project if
Calculated PI < 1
Discounted Payback Period

• Determines the length of time required for an
investment cash flows, discounted at the
investments cost of capital, to cover its cost
Decision Rule – Discounted Payback Period
Maximum
Accept Project
if Calculated
DPB
≤ Allowable
Discounted
Payback
Maximum
Reject Project if
Calculated DPB > Allowable
Discounted
Payback
Payback Period
• Length of time required for a project’s
cumulative net cash inflows to equal its net
investment
• Measures the time required for a project to
break even
Net Investment
Payback Period
(Equal annual
net cash
inflows)
Annual Net Cash Inflows
Unrecovered cost at start

Payback Period Number of of year
(Unequal years prior
annual net cash to full
inflows) recovery
Cash flow during full
recovered
Decision Rule – Payback Period
Maximum
Accept Project
if Calculated PB ≤ Allowable
Discounted
Payback
Maximum
Reject Project if
Calculated PB > Allowable
Discounted
Payback
Bail-out Period
• Length of time required to repay the total
initial investment through investment cash
flows combine with the salvage value
Decision Rule – Bailout Period

• The shorter the payback period, the more
attractive a company is.
Payback Reciprocal
• Measures the rate of recovery of investment
during the payback period
1
Payback
Reciprocal
Payback period
Net cash inflows

Payback
Reciprocal
Investment
Decision Rule – Payback Reciprocal
The higher the payback period reciprocal, (and

hence the lower the payback period) the more
worthwhile the projects becomes.
Accounting Rate of Return

• Also called as simple rate of return
• Measure of a project’s profitability from a
conventional accounting standpoint by relating
the required investment to the future annual
net income
Average annual net

income
Accounting
Rate of Return
Average Investment
Average annual net

income
Accounting
Rate of Return
Initial Investment
Cost of Savings - Depreciation on new equipment
Accounting
Rate of Return
Initial Investment or Average Investment

Decision Rule – ARR
Accept Project
if Calculated
ARR
≥ Required rate
of return
Reject Project if
Calculated ARR < Required rate
of return
Accept-
Reject This occurs when an individual project
Decisions is accepted or rejected without regard
to any other investment alternatives
Selection of the investment
proposals in a situation of
constraint on availability of
capital funds, to maximize
the wealth of the company
by selecting those projects
Types of
which will maximize overall Capital These are competing
NPV of the concern Budgeting investment proposals that
Decisions will perform the same
Mutually function or task. The
Capital acceptance of one or a
exclusive
Rationing combination of projects
project
Decisions eliminates the others form
decisions further consideration.
• Basic form of “what-ifs”

• Involves the determination of what
Scenario
happens to NPV estimates when we
• Measures the company’s equity Analysis
ask “what-if” questions
market value changes with changes
in the overall market
• Used in the CAPM
• Process of changing
Methods of one or more
Beta Estimating & Sensitivity variables to
Estimation Measuring Analysis
Risk
determine how
sensitive a project’s
returns are to these
changes
• Involves the CAPM

• It measures the systematic risk of a Simulation
project Analysis
Problem 1
Project A has a net cash inflows of P120,000
and annual net cash inflows of P50,000 for
five years. Calculate the Project A’s net
present value using a 16% discount.
Problem 2
XYC Company has P200,000 funds available for investment. It is
considering the following projects: (Compute the PI)
A B C
PV of Annual Cash 244,000 130,000 130,000

Inflows
Less: Investment 200,000 100,000 100,000
required
NPV 44,000 30,000 30,000
Problem 3
A project requiring an investment of P170,000 is expected to
generate the following cash inflows:
Year Amount
1 60,000
2 60,000
3 60,000
4 60,000
5 60,000
Problem 4
The information provided below pertains to Project A of the Maharlika Corporation.
The maximum payback period set by the firm is three years.
Project A
Net Investment 120,000
Annual net cash inflows 50,000
Estimated life 5 years

Assessing Long-Term Debt, Equity and Capital Structure

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St.

Market Market Value of

Modigaliani & Miller Approach I

Modigaliani & Miller Approach II

Value of a Value of the

Sources Hybrid Financing

Unsecured loan; these can be issued

Bonds with staggered

Pay interest only if the issuing company

Type of Lease Characteristics

Type of Lease Characteristics

Type of Lease Characteristics

Type of Lease Characteristics

Direct Leases the leased asset

Type of Lease Characteristics

a. Common stocks c. Preferred stocks

a. Issuance of stock dividend

Capital Budgeting Decisions

Financing Decision Investment Decision

Commonly used methods of evaluating capital

Net Present Value

Net Present Value

Net Present Value

Net Present Value

Decision Rule – NPV

Internal Rate of Return

Net cost of investment

Net cash inflows

Decision Rule – IRR

Accept Project Cost of

Total present value of

Total present value of

Net Present Value

Discounted Payback Period

Decision Rule – Discounted Payback Period

Unrecovered cost at start

Decision Rule – Payback Period

Decision Rule – Bailout Period

Net cash inflows

Decision Rule – Payback Reciprocal

The higher the payback period reciprocal, (and

Accounting Rate of Return

Average annual net

Average annual net

Cost of Savings - Depreciation on new equipment

Initial Investment or Average Investment

Decision Rule – ARR

• Basic form of “what-ifs”

• Involves the CAPM

PV of Annual Cash 244,000 130,000 130,000

Estimated life 5 years

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