4BSA Strategic Management

07 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 the 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 overall 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)

Financial management requires thorough analysis of the firm's capital requirements. Generally, the ‘additional (external) funds needed' can
be determined by using the following formula:

Required increase in assets → ∆ in Sales x (Assets ÷ Sales)

- Spontaneous increase in liabilities → ∆ in Sales x (Liabilities ÷ Sales)
- Increase in retained earnings* → Earning 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 FINANCING DECISIONS

 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.
 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.
 FINANCIAL FLEXIBILITY - the firm's ability to raise capital on reasonable terms even under adverse conditions.
 MANAGERIAL AGGRESSIVENESS - refers to some financial managers' inclination to use more debt to boost profit.

Exercises
1. Additional Funds Needed
Bea Corporation's sales are expected to increase from P 5,000,000 in 2018 to P 6,000,000 in 2019. Its assets totaled P 3,000,000 at the end
of 2018. Bea has full capacity, so its assets must grow in proportion to projected sales. At the end of 2018, current liabilities are P 1,000,000
(of which P 400,000 are accounts payable, P 100,000 accruals and P 500,000 notes payable). The after-tax profit margin is projected to be
10%. The forecasted pay-out ratio is 75%.

REQUIRED:
Determine the additional funds needed from external sources.

Solution guide

Increase in assets
- increase in liabilities
- Increase in retained earnings
ADDITIONAL FUNDS NEEDED

Key financial ratios

 Capital intensity ratio = assets ÷ sales
 After-tax profit margin = after-tax profit ÷ sales
 Dividend payout ratio = dividends ÷ earnings = dividends per share ÷ earnings per share
 Retention ratio = 100% - dividend payout ratio
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07 Long-term Financing Decisions

2. Targeted Capital Structure

Omega Company has the following capital structure:

Debt (16%) P 750,000,000

Preferred stock (12.5%, P100 par) 300,000,000
Common stock (P10 par) 1,000,000,000
Retained earnings 450,000,000
TOTAL P 2,500,000,000

Omega Company considers the following options for the financing of its planned expansion that requires additional external financing for
P300,000,000:

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

OPTION B
 20% borrowing at 18%
 15% preferred stock at 12.5% to be issued at par
 65% common stock 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?
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07 Long-term Financing Decisions

Sources of intermediate and 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 capital 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 structure intact.

2. External Sources
 DEBT (Bond) FINANCING
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 (Common Stock) FINANCING

The sale of common stock is frequently more attractive to investors than debt because it grows in value with the success of the
firm. The higher the common stock value, the more advantageous equity financing is over debt financing

 HYBRID FINANCING
These are sources of funds that possess a combination of features; these include preferred stock, leasing, and option securities
such as warrants and convertibles.

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

 LEASE FINANCING
Lease - a rental agreement that typically requires 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 requirement to maintain minimum debt-equity ratios of minimum level of liquid assets.
Basic difference: ownership of the asset

Leasing Benefits
 Increased Flexibility - in some cases, 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:
1. OPERATING LEASE - usually short-term and often cancelable; obligation is not shown on the balance sheet, maintenance
and upkeep of asset 1s usually provided 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.
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07 Long-term Financing Decisions

 CONVERTIBLE SECURITIES - preferred stock or bond issue that can be exchanged 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.

 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 an incentive
for investors to buy the combined issue at a lower interest rate

 OPTION - it is a contract that gives its holders the right to buy (or sell) stocks at some predetermined price (usually less than
stock’s market prices) within a specified period of time