Chapter 18

Long Term Financing Decisions

Financial structure- the mix of all assets which appear on the right-hand side of the companys balance sheet Capital structure- pertains to the mix of the long term sources of funds

Financial structure Current liabilities= Capital Structure

Long Term financing generally refers to financing with a maturity of more than five years. Long term financing is often used to finance long lived assets, such as land or equipment, or construction projects. The more capital intensive the business, the more it should rely on long term debt and equity. A business enterprises mix of long term funds is usually referred to as its capital structure. The ideal capital structure maximizes the total value of the enterprise and minimizes the overall cost of capital. Managers charged with formulating an appropriate capital structure should take into account the nature of the business and industry , the business enterprises strategic business plan , its current and historical capital structure, and its planned growth rate. Capital structure management aims to mix the permanent sources of funds used by the firm in a manner that will maximize the companys ordinary share price or to search for the funds mix that will minimize the firms cost of composite capital.

Tools of Capital Structure Management

When a firm expands, it needs capital, and that capital can come from debt or equity. The use of debt tends to increase earnings per share (EPS), which will lead to a higher stock price, but at the same time, the use of debt also increases the risk borne by shareholders, which lowers the stock price. Capital structure management is closely related to cost of capital. This mix called the optimal capital structure minimizes the overall cost of capital. The optimal capital structure strikes a balance between these risk and return factors. However not all financial managers believe that an optimal structure actually exists. Disputes over this question center on whether a business can , in reality, affect its valuation and its cost of capital by varying the mixture of the fund it uses. While it is difficult to determine the optimal capital structure with precision, it is possible to identify the factors that influence it. The decision to use debt and/ or preference share in capitalization results in two types of financial leverage effects. The first effect is an increased risk to EPS caused by the use of fixed

financial obligations. The second effect relates to the level of EPS at a given EBIT under a specific capital structure. EBIT-EPS analysis is used to measure this second effect. Just like in capital budgeting process, the management has to understand the ff. terms before it can finally evaluate an appropriate capital structure. These are: Financial structure, leverage, and cost of capital. 1. Financial Structure- is the mix of items on the right hand side of the firms balance sheet or its total liabilities and equity section. 2. Leverage- is the cost structure , in which the fixed cost represent a risk to the firm. It is composed of the operating leverage and financial leverage. a. Operating Leverage- is used to measure operating risk which refers to the fixed operating cost. It is the use of fixed operating cost in the firms cost structure. When operating leverage is present. Any percentage fluctuations in sales will result in a greater percentage fluctuations in earnings before interest and taxes (EBIT). Operating leverage is the responsiveness of a firms EBIT to fluctuations in sales. b. Financial leverage- is used to measure of financial risk, which refers to financing a portion of the firms assets. The higher the financial leverage, the higher the financial risk, the higher cost of capital. A measure of the firms use of financial leverage is as follows: 3. Cost of capital- is the rate of return that is necessary to maintain the market value of the firm. It is also called the minimum required rate of return used to measure and evaluate capital budgeting, capital structure , leasing decisions and even short term financing decisions.

1. Cost of debt: K1= I + (M-V)/n (M-V)/2 I= annual interest payments M= par or face value V= Market value or net proceeds from sale of a bond N= term of bond in years 2. Cost of Preference share Kp= Dp P

Dp=annual pref. share dividend

P= net proceeds 3. Cost of Equity Capital Gordons Growth Model Po= D1 r-g Po= value of ordinary share capital D1= dividend to be received in 1 year R= investors required rate of return G= rate of growth D1 +g Po 4. Cost of retained Earnings Ke=Ks Measuring overall cost of capital Ko= of capital of each source =wdkd + wpkp + weke + wsks Where wd= % of total capital supplied by debts Wp=% of total capital supplied by preference shares We= % of total capital supplied by external equity Ws= % of total capital supplied by retained earnings or internal equity x Cost Ke=

Factors influencing Capital structure

Business Risk- is defined as the uncertainty inherent in projections of future returns on assets, or on equity (ROE), assuming the firm uses no debt. The firms asset structure is the primary determinant of its business risk .This varies from industry to industry and also among the firms in the same industry and may change overtime. Business risk is the residual effects of the companys a. Companys cost structure b. Product demand characteristics

c. Intra- industry common position The risk depends on the ff. factors a. Demand variability b. Sales price variability c. Input price variability d. Ability to adjust selling prices for changes in input prices e. Operating leverage or the extent to which cost are fixed

Firms tax position- Interest is a deductible expense, and deductions from income subject to income taxes usually make the difference in deciding capital structure. The higher the firms tax rate, the use of debt capital is preferred. Though some point where the expected cost of default is large enough to outweigh the tax shield advantage of debt financing, turning to common equity financing is justifiable.

Financial Flexibility- This pertains to the ability of the firm to raise capital on reasonable terms under adverse conditions. The larger the potential future funds requirements the greater the need for reserve borrowing capacity and hence the lower the optical debt ratio. Managerial aggressiveness- This refers to some finance managers aggressiveness or inclination to use more debt in an effort to boost profits. This factor however, does not affect the optimal or value-maximizing capital structure , but it does influence the target capital structure.

Incorporating Capital Structure into Capital Budgeting Capital Budgeting is the process of making long term investment decisions that further the business enterprises goals. The shareholders have entrusted the business enterprise with their money, and they expect the business enterprise to invest their money wisely. Investments in fixed assets should be consistent with the goal of maximizing the market value of the business enterprise. To make long term investment decisions in accordance with the business enterprises goals you must perform three tasks when evaluating capital budgeting projects: (1) estimate cash flows, (2) estimate the cost of capital , (3)apply a decision rule to determine whether a project will be good for the business enterprise. Furthermore, if the source of long term capital is limited there may be a need for management to place a constraint or absolute limit on the size of the firms capital budget

during a particular period. This is known as Capital Rationing or Optimal Capital Budget Determination. Establishing the Optimal Capital Budget in Practice The basic procedures involved in establishing the optimal capital budget are: 1. Prepare the Investment Opportunity schedule (IOS) showing the firms investment opportunities ranked in order of the projects rate of return or Internal Rate of Return (IRR) 2. Prepare the Marginal Cost of Capital(MCC) schedule showing the weighted average cost of capital. 3. Prepare a graph that combines the IOS and MCC schedules and the intersection defines the firms marginal cost of capital for the use in capital budgeting. The discount rate is influenced both by the shape of the MCC curve and by set of available projects. 4. Determine the firms retained earnings breakpoint by dividing the Retained Earnings by Equity Fraction or %. Retained earnings breakpoint is the point at which the marginal cost of capital increases. 5. Each Projects Net Present value is then determined using its adjusted cost of capital. The optimal capital budget consists of all independent projects with positive NPVs plus those mutually exclusive projects with the highest positive risk adjusted NPVs 6. Accept all independent projects that have rates of return in excess of the cost of the capital that will be used to finance them, and reject all others. Illustrative Case: Capital Rationing: Capital Rationing is the process of selecting the mix of acceptable projects that provides the highest overall NPV. The profitability index is widely used in ranking projects competing for limited funds. A business enterprise with a fixed capital spending Budget of P250 000 needs to select a mix of acceptable projects from the following

Projects Apple Orange Cherry Strawberry Grapes

I (P) 70 000 100 000 110 000 60 000 40 000

PV(P) 112 000 145 000 126 500 79 000 38 000

NPV(P) 42 000 45 000 16 500 19 000 -2 000

Profitability Index 1.6 1.45 1.15 1.32 0.95

Ranking 1 2 5 3 6

Kiwi

80 000

95 000

15 000

1.19

The ranking derived from the Profitability Index shows that the business enterprise should select projects Apple, Orange, and Strawberry.

I Apple O range Strawberry P 70 000 100 000 60 000 P230 000 Therefore, NPV= 336 000 - 230 000= P106 000 Illustrative Case: Cost Of Capital Determination:

PV P 112 000 145 000 79 000 P 336 000

Cost of capital: is defined as the rate of return that is necessary to maintain the market value of the firm. The cost of capital must be known in order to: a. Make capital budgeting decisions b. Help to establish the optimal capital structure c. Make decisions concerning leasing, bond refunding , and working capital management The following tabulation gives the EPS figure for the Jelly Bean Company during the preceding 5 years, the firms ordinary shares, P7.8 M outstanding is now selling for P65 and the expected dividend at the end of the current year (2010) is 55% of the 2005 EPS. Because investors expect past trends to continue g may be based on the earnings growth rate Year 2005 2006 2007 2008 EPS 5.73 6.19 6.68 7.22

2009

7.80

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

Debt Ordinary Equity Total liabilities and Owners Equity

P104M 156M 260M

Required: 1. Calculate Jelly Beans after tax cost of new debt and of ordinary equity , assuming that the new equity comes from retained earnings. 2. What is the firms 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 firms weighted average cost of capital is new ordinary shares can be sold to the public at P65 per share to net the firm P58.5 per share? The cost of debt is constant.

Analysis and Solution: 1. A. Cost of Debt Kd= 9%(1-32%) = 6.12% B. Cost of Equity Ks= P4.29 +8% P65 = 14.6%

Dividend per share of P4.29 was calculated by applying the payout rate on EPS for 2009 (55% x P7.80) . The growth rate for 5 years is reflected on the EPS data. 2. The weighted average cost of capital is computed as follows:

Cost of Capital Debt Ordinary Equity 6.12% 14.60% WACC

Weight 40% 60%

Weighted Cost of Capital 2.45% 10.23% 12.68%

3. Earnings per share Multiplied by:Outstanding ordinary Shares Earnings after tax Less:Dividends to ordinary Shareholders(55%) Earnings Available for capital investment

7.80 7 800 000 P57 720 000 31 746 000 25 974 000

4. The weighted average cost of capital (cost of funds raised in excess of the amount calculated in part 3) if the new ordinary shares can be sold to the public at P65 per share to net the firm P58.50 a share is calculated as follows:

Cost of Capital Debt Ordinary Equity 6.12% 15.33% WACC 4.29 +8% 58.50

Weight 40% 60%

Weighted Cost of Capital 2.45% 9.20% 11.65%