Module No.

5 – Long Term Financing

Learning Outcome/s:
 Determine the sources of long-term financing and their corresponding benefits and drawbacks
 Familiarize with capital rationing
 Compute the cost of debt and cost of equity
 Determine the effect of operating and financial leverage in financing decisions

Core Values/Biblical Principles:

“As for me, I will always have hope; I will praise you more and more. My mouth will tell of your
righteous deeds, of your saving acts all day long—though I know not how to relate them all. I will come
and proclaim your mighty acts, Sovereign Lord; I will proclaim your righteous deeds, yours alone.”
Psalms 71:14-16

Body:
The principal sources of funds may be broken into these general categories:
1. External
a. Debt
b. Equity
c. Hybrid
2. Internal
a. Operations

DEBT FINANCING

 Benefits of debt financing

1. Interest payment is tax deductible thereby reducing the weighted average cost of capital to
the firm.
2. There is no dilution or loss of control with the issuance of debt instruments.
3. The financial obligations, is clearly specified and of a fixed nature (with the exception of
floating rate bonds).
4. In an inflationary economy, debt may be paid back with "cheaper pesos"

 Drawbacks of debt financing

1. Interest and principal payments obligations are set by contract and must be met, regardless
of the economic position of the firm.
2. The fixed interest charge increases the bankruptcy risk to equity holders if the earnings of
the company fluctuate because the corporation may be unable to meet these fixed charges.
The higher risk brings on a higher capitalization rate for equity earnings.
3. Indenture provisions are likely to be much more stringent and may limit the firm's future
financial flexibility.
4. Used beyond a given point, debt may depress the market values of the outstanding ordinary
shares.

 Category based on the maturity of the financing agreement

o Short-term sources which have a maturity of one year or less
 o Intermediate-term financing which includes all financing arrangements having final
maturities longer than I year but no longer than 10 years.
o Long-term financing which includes all forms of financing with final maturities longer
than 10 years.

 TERM LOANS
 Characteristic of term loans
o They have maturities of 1 to 10 years.
o They are repaid in periodic installments such as quarterly, semi-annually or annual
payment.
o They are usually secured by a chattel mortgage on equipment or a mortgage on real
property.

 Advantages of term loans and long-term debt

1. There is more flexibility as to the terms and costs of the loan itself since the firm is dealing
only with one creditor or the leader in a loan syndicate among banks.
2. The term loan approach requires much less release of confidential or sensitive firm
information to potential or actual competition.

 Disadvantages of term loans

1. Effective costs of term loans are higher because of periodic installment requirement.
2. The bank as lender may impose some very restrictive arrangement in the loan agreement
relative to company operation

 BONDS OR LONG-TERM DEBT

- Bonds are any long-term promissory note issued by a firm
- Indenture – the legal agreement between the issuing firm and the bond trustee who represents
the bondholders

 Classification of bonds according to the collateral

1. Debenture bonds – represent the unsecured loan to the company
2. Subordinated debentures – bonds whose claims are honored only after the claims of
secured debt and unsubordinated debentures have been satisfied
3. Income bonds – bonds on which the interest is payable only if earned
4. Mortgage bonds – debt instruments accompanied by a pledge of property by the issuing
firm
5. Floating rate or variable rate bond – instruments that pay interest initially at about 1%
above the treasury bill rate

 RETIREMENT OF BONDS
- If bonds are retired at maturity, the bondholders receive the par value of the bond or they can
be retired prior to maturity

EQUITY FINANCING

 ORDINARY SHARES
 - Ordinary shares brings with it the right to share in the profits as well as the losses of this
business
- Important control feature of many ordinary shares is the preemptive right.
o Preemptive right – gives the current shareholders the first chance to purchase newly
issued ordinary shares and newly issued securities convertible into ordinary shares
 The financial value of the right is a function of the number of rights required to
purchase one new share and the subscription price of that one new share

 Advantages of ordinary shares as a source of funds

1. Ordinary share does not oblige the firm to make payments to shareholders.
2. Only if the company generates earnings and has no pressing internal needs for capital will it
pay dividends.
3. Ordinary share carries no fixed maturity date. It never has to he "repaid" as would a debt
issue.
4. The sale of ordinary share increases the creditworthiness of the firm because they provide
additional cushions to creditors against losses.
5. The ordinary share can often be sold on better terms than debt if the company's prospects
look bright.
 Disadvantages of ordinary shares as a source of funds
1. Issuance of ordinary shares may dilute control and earnings of the present stockholders.
2. Costs of underwriting and distributing ordinary shares are usually higher than those for
preference share or debt.
3. Dividends on ordinary shares are not deductible as an expense for tax purposes.
4. If the firm has more equity than called for in its optimal capital structure the average cost of
capital will be higher than necessary

 RETAINED EARNINGS
- One of the important source of long-term equity funds
- During periods of capital rationing, retained earnings is the only large and quickly available
source of capital funds for many firms
- The risk associated with retained earnings is the same as that for ordinary share since retained
earnings are equivalent to additional capital investment on the part of existing shareholders

FINACIAL STRUCTURE AND CAPITAL STRUCTURE

Financial Structure Capital Structure

Mix of all assets which appear on the right-hand
side of the company’s statement of financial Mix of the long-term sources of funds
position

Relationship between financial and capital structure can be expressed in the following expressed:
Financial structure – Current liabilities = Capital structure
Financial structure design necessitates consideration of the following issues:
1. What should be the maturity composition of the firm’s sources of funds?
2. What should be the proportion of the various forms of financing to be utilized to the total
financing required?
 Capital-structure management – aims to mix permanent sources of funds used by the firm in
manner that will maximize the company’s ordinary share price or to search for the funds mix that
will minimize the firm’s cost of composite capital

FACTORS INFLUENCING CAPITAL STRUCTURE DECISIONS

1. Business risk
2. The firm’s tax position
3. Financial flexibility
4. Managerial aggressiveness

 Capital Rationing or Optimal Capital Budget Determination – If the source is limited, there may be
a need for management to place a constraint or absolute limit on the size of the firm’s capital
budget during a particular period.

Sample problem no. 1

The Clear Glass Company uses a process of capital rationing in its decision making. The firm’s cost of
capital 13%. It will only invest P60 Million this year. It has determined that the internal rate of return for
each of the following projects:
Project Project Size Internal Rate of Returns
A P10M 15%
B 30M 14%
C 25M 16.5%
D 10M 17%
E 10M 23%
F 20M 11%
G 15M 16%

Required:
1. Determine the projects that the firm should accept
2. If projects D and E are mutually exclusive, how would that affect your overall answer? That is
which projects would you accept in spending the P60M?

COST OF CAPITAL DETERMINATION

 Debt = Interest rate(1−tax rate)

Dividends per share

 Ordinary shares = +Growth rate
Market price per share

Dividends per share

 Preference shares =
Market price per share

Dividends per share

 Preference shares =
Earnings per share ( EPS )−flotation costs

(Net Income – Preferred Dividends)

 Earnings per share (EPS) =
Weighted Average Number of Common Shares
Sample Problem no. 2
The following tabulation gives earnings per share (EPS) figure for the Magic Company during the
preceding 5 years. The firm’s ordinary shares, 7.8M outstanding is now selling for P65 and the expected
dividend at the end of the current year (2010) is 55% of the 2009 EPS. Because investors expect past
trends to continue, “g” may be based on the earnings growth rate:

Year EPS
2009 5.73
2010 6.19
2011 6.68
2012 7.22
2013 7.80

The current interest rate on new debt is 9%. The firm’s marginal tax rate is 32%. Its capital structure,
considered to be optimal, is as follows:

Debt P104M
Ordinary Equity 156M
Total liabilities and equity P260M

Required:
1. Calculate Magic’s after-tax cost of new debt and of ordinary equity, assuming that the new
equity comes only from retained earnings
2. What is the firm’s weighted average cost of capital, again assuming that no new ordinary share
is sold and that debt costs 9%?
3. How much can be spent on capital investments before external equity (ordinary shares) must be
sold?
4. What is the firm’s weighted average cost of capital if new ordinary share can be sold to the
public at P65 per share to net firm P58.50 per share? The cost of debt is constant

EFFECT OF OPERATING LEVERAGE AND FINANCIAL LEVERAGE ON CAPITAL STRUCTURE

 Operating Leverage – the degree to which a firm uses fixed costs in the production processes.

Percentage changes ∈EBIT Contribution Margin

DOL = ∨
Percentage change ∈Sales EBIT

 Financial Leverage – the firm’s use of fixed charge securities such as debt and preference shares
in its capital structure

EBIT
DOL =
EBIT−Interest

 Degree of Total Leverage – It shows the effect of operating and financial leverage on earnings per share.
 Contribution Margin
DTL = ∨( DOL)( DFL)
EBIT −Interest

Sample Problem no. 3

The Snowbelll Company manufactures skates. The company’s income statement for 2013 is as follows:

SNOWBELL COMPANY
Income Statement
For the year ended December 31, 2013

Sales (10,000 skates @ P50 each)……………………………………………….P500,000

Less: Variable Costs (10,000 skates at P20)…………………………………..200,000
Fixed Costs……………………………………………………………………..150,000
Earnings before interest and taxes (EBIT)……………………………………P150,000
Interest expense………………………………………………………………………… 60,000
Earnings before taxes (EBT)……………………………………………………………90,000
Income Tax Expense…………………………………………………………………… 36,000
Earnings after taxes (EAT)…………………………………………………………....P54,000

Given this income statement, compute the following.

a. Degree of operating leverage
b. Degree of financial leverage
c. Degree of combined leverage
d. Break-even point in units (number of skates)

DETERMINING THE OPTIMAL CAPITAL STRUCTURE

- Optimal Capital structure is found when the expected stock price is maximized and management should
set its target capital structure at this ratio of debt to assets

Sample Problem no. 4

Brown Products is a new firm just starting operations. The firm will produce backpacks which will sell for p22.00 a
piece. Fixed costs are P500,000 per year and variable costs are P2.00 per unit of production. The company expects
to sell 50,000 backpacks per year, and its effective tax rate is 40%. Brown needs P2,000,000 to build facilities,
obtain working capital, and start operations. If Brown borrows part of the money, the interest charges will depend
on the amount borrowed as follows:

Interest Rate on Total Amount

Amounts Borrowed % of Debt in Capital Structure
Borrowed
200,000 10 9.00
400,000 20 9.50
600,000 30 10.00
800,000 40 15.00
1,000,000 50 19.00
1,200,000 50 26.00
Assume that stock can be sold at a price of P20 per share on the initial offering, regardless of how much debt the
company uses. Then after the company begins operating, its price will be determined as a multiple of its earnings
per share. The multiple (or the P/E ratio) will depend upon the capital structure as follows:

Debt/Assets P/E Debt/Assets P/E

0.0 12.5 40.0 8.0
10.0 12.0 50.0 6.0
20.0 11.5 60.0 5.0
30.0 10.0

Required:
1. What is Brown's optimal capital structure, which maximizes stock price, as measured by the
debt/assets ratio?
2. What is Brown's degree of operating leverage at the expected level of sales?
3. What is Brown's degree of financial leverage at the expected level of sales?
4. What is Brown's degree of total leverage at the expected level of sales and optimal capital
structure?

Reference:

Management Consultancy: Principle and Engagements by Elenita Balatbat Cabrera, BBA, MBA, CPA, CMA