Long Term Financing

Download as pdf or txt
Download as pdf or txt
You are on page 1of 47

CHAPTER 9:

LONG TERM FINANCING


Chapter Content
1. Types – Bonds, Preferred Shares
and Common Stock
2. Characteristics of Bonds, Preferred
Shares and Stock
3. Advantages and disadvantages of
these instruments
4. Cost of financing
Chapter Objective
At the end of this chapter, learners will be
able to:
◦ Know how to determine a firm’s cost of debt
◦ Know how to determine a firm’s cost of equity
capital
◦ Know how to determine a firm’s overall cost of
capital
◦ Understand pitfalls of overall cost of capital and
how to manage them
Introduction
Capital is a necessary element of production,
without which the firm cannot operate.
All firms need to secure proper financing
sources, from debt to equity, to support its
operations especially when involves in large
capital expenditures.
Cost of capital is the minimum rate of return
that the firm must earn on its capital
investment project in order to satisfy the
required rate of return of the firm’s investors.
Introduction
Or should I
Should I use capital
borrow? instead?
INTRODUCTION
Three sources of long term financing

✔ Debt/bond
⚫ Preferred stock
⚫ Common equity – common stock and
retained earnings
Debt
The use of debt will result in a fixed
obligation that needs servicing regardless
of the financial conditions of the firm.

How I can afford to


pay?
Debt
Debt represents a source of permanent
financing used extensively to support capital
investment.
Varieties of long-term instruments:
◦ Convertible
● Gives the holder the options to exchange the debt
issue for a specified number of firm’s common shares
during a specified period.
◦ Straight or non-convertible
Features of Long-Term
Debts
Fixed Interest Rate
◦ Fixed obligations that must be serviced when due.
Fixed Maturity Date
◦ The maturity date for debt instrument is fixed at
which the issuer must make the final payment when
it is due.
Preference of Debt Financing
over Equity Financing
Management control
◦ Debt holders do not participate in the company’s
management and decision-making under normal
circumstances.
Cost of funds
◦ Cost of debt is cheaper as interest paid to debt
holders are tax deductible.
Types of Debt

Term
Bond
Loans

Long-ter
m Debt
Term Loans
Can be obtained in a short time, flexible and
low issuance costs with maturity of more than
5 years.
Sources: banks, insurance company, or
pension fund.
May have fixed or variable interest rates.
Bond
A long-term promissory note issued by a
government or business unit that obligates
the issue to make periodic interest payments
and the principal payment at maturity date to
the holder.
Bond Characteristics/
Features

Coupon Yield to
Par Value
Interest Rate Maturity

Bond
Call Provision Bond Ratings
Maturities
Bond Characteristics/
Features
Par Value Call Provision
◦ The stated face value of the ◦ Gives the issuing firm the
bond, usually RM1,000. right to call-in the bond
Coupon Interest Rate before maturity.
◦ Percentage of par value of the
bond that will paid out
Bond Ratings
periodically to the bondholders ◦ Serve as a qualitative guide
in the form of interest to the probability of default.
payments.
Bond Maturities
◦ Interest payment can be paid
annually or semi annually. ◦ The date on which the par
value of the bond is to be
Yield to Maturity (YTM)
repaid to the bondholders.
◦ The rate the bondholder would
earn if they bought the bond, ◦ Maturities generally vary
held it until maturity and from five to forty years.
reinvested the interest earned.
Bond Categories

Bond Categories

Secured Unsecured

Bonds Issued
Convertible with Stock Indexed Zero Coupon Subordinates
Debentures Income Bonds
Bonds Purchase Bonds Bonds Debenture
Warrants
Bonds
Convertible Bonds Debentures
◦ Bonds that may be exchanged for ◦ Long-term claims issued by
shares of common stock. credit worthy companies that is
Bonds issued with Stock Purchase not secured by any specific
Warrants assets of the company.
◦ Similar to convertible bonds; allows Subordinated Debenture
the holder to buy the stock at ◦ Also known as junior debt;
some agreed upon fixed prices.
entitles the bondholder to get
Indexed Bonds settlement after all senior
◦ Bonds that have interest rates creditors are paid in case of
pegged to some price index. liquidation.
Zero Coupon Bonds Income Bonds
◦ Bonds sold at deep-discount below ◦ Pay interest only when the firm
par value. earns enough profits to pay
◦ There are no cash outlays for interest.
interest or principal payments until
maturity.

Secured Bonds Unsecured Bonds


Bond Valuation

Present Value of Bond, B0 = CP (PVIFAk,n) + M (PVIFk,n)

Where:
CP Coupon payment
M Maturity Value
k Discount rate or rate of return
n Period to maturity
Illustration

Lets assume that TM Afic Inc. plans to issue


RM1,000 of bonds that have a face value of
RM1,000 and an annual coupon interest of
12% for 10 years. Due to high interest rates,
it can be sold for RM950 each with issuance
cost of 5%.
Workings

Present Value of Bond, B0 = CP (PVIFAk,n) + M (PVIFk,n)


= 120(PVIFA12%,10)+ 1,000(PVIF12%,10)
= RM1,000
Cost of debt
The cost of debt is the required return on our
company’s debt.
The required return is best estimated by
computing the yield-to-maturity on the
existing debt.
The cost of debt is NOT the coupon rate.
1. BONDS/DEBT

Calculation on the cost of bond if it is sold


at par value

Kb = Annual Interest
Par Value

Kb (after tax) = kb (1 - tax rate)


Example 1
Malcom Bhd were issued last week with 12 years
maturity and coupon rate of 10%. It is currently
selling at RM1000. If the tax rate is 35%, what is the
cost of fund?

Solution:
Kb = Annual Interest
Par Value
= 100 / 1000
= 0.1
Kb (after tax) = kb (1 - tax rate)
= 0.1 (1-0.35)
= 6.5%
Calculation on cost of debt if it sold below
or above par value
on cost of debt if it sold below or above par
If there is a flotation cost (i.e broker’s
value fees, commission fees, legal fees and
underwriting fees)

Kdb = C/m + (PV – (MP- FC)


nxm
PV + (MP-FC)
Where: 2
C = coupon payment
m = how many times the coupon payment is paid in a year
n = years remaining to maturity
P = par value (RM1000)
MP = Market price
FC = Flotation Cost
Example 2
⚫ Tenong Bhd is considering to issue bond with 11% coupon rate.
Market price is RM900 and maturity period is 20 years. The
marginal tax rate of the firm is 40%. Calculate the cost of issuing
the bond.

Solution:
Kb = 110 + (1000 – 900)
20 a
1000 + 900
2
= 12.11%

Kb (after tax) = kb (1 - tax rate)


= 0.1211 (1-0.4)

= 7.27%
Example 3
Lets assume that TM Afic Inc. plans to issue
bonds that have a face value of RM1,000 and
an annual coupon interest of 12% for 10
years. Due to high interest rates, it can be
sold for RM950 each with issuance cost of 5%.
Assume the tax rate is 40%.
Workings
Cost of Debt before Tax, Kb = 120 + 1,000 – (950 – 50)
( )
10
1,000 + (950 – 50)
2
= 13.68%

Cost of Debt, Kat = Kat (1 – T)


= 13.68 ( 1- 0.4)
= 8.21%
2. Preferred Stock
Preferred stock is an equity security but it has
characteristics similar to debt. This includes:
◦ Par value normally stated at RM100 per share.
◦ Fixed annual dividend payments stated in
percentage of the par value.
◦ Participating dividend based on prescribed formula
as agreed upon during the issue.
◦ Claims on earnings and assets.
◦ Dividends are paid prior to common stock holders.
Cost of Preferred Stock
After-tax cost of Preferred Stock, KPS = DPS
(P0 – FC)

Selling Price of the Preferred Stock, P0 = DPS


KPS

Where:
DPS Preferred Shares Dividend
P0 Selling Price of Preferred Shares
FC Floatation Cost
Example 4
TM Afiq plans to issue RM1,000,000 of RM100 par preferred stock
that pays 10% dividend. The market price of the issues is RM98
with 5% floatation cost. Calculate:
a) after-tax cost of the preferred issues.
b) selling price of preferred stock.

After-tax Cost of Preferred Stock, KPS = DPS


(P0 – FC)
= (100 x 10%)
98 – 5
= 10.75%

Selling Price of Preferred Stock, P0 = DPS


KPS
= (100 x 10%)
0.1075
= RM93.02
Example 5
Royan Industries decide to expand its business
and RM45,000,000 worth of external funds need
to be raised. One alternative source of financing
is to issue a preferred stock paying 9% dividend
on a RM100 par value. The cost of issuing these
stocks is estimated to at 12% of the current
price of RM160. Calculate:
a) after-tax cost of the preferred issues.
b) selling price of preferred stock.

Answer: a)6.08% b)RM148


Common Equity
Represents an ownership of the firm.
Ownership position will directly depend on
the amount of common shares held relative
to the total number of common shares
outstanding in the market.
Common stockholders are the real owners of
the firm.
Cost of Equity
The cost of equity is the return required by
equity investors given the risk of the cash
flows from the firm.
There are two major methods for determining
the cost of equity:
◦ Dividend growth model
◦ SML or CAPM
The Dividend Growth Model
Approach
Start with the dividend growth model formula
and rearrange to solve for RE
Dividend Growth Model
Example
Suppose that your company is expected to
pay a dividend of RM1.50 per share next
year. There has been a steady growth in
dividends of 5.1% per year and the market
expects that to continue. The current price
is RM25.
What is the cost of equity?
Dividend Growth Model
Example
The SML Approach
Use the following information to compute our
cost of equity
◦ Risk-free rate, Rf
◦ Market risk premium, E(RM) – Rf
◦ Systematic risk of asset, β
SML Example
Suppose your company has an equity beta
of 0.58 and the current risk free rate is
6.1%.
If the expected market risk premium is
8.6%, what is your cost of equity capital?
SML Example

Since we came up with similar numbers


using both the dividend growth model and
the SML approach, we should feel pretty
good about our estimate.
Cost of Equity Example
Suppose our company has a beta of 1.5.
The market risk premium is expected to be
9% and the current risk-free rate is 6%. We
have used analysts’ estimates to determine
that the market believes our dividend will
grow at 6% per year and our last dividend
was RM2. Our stock is currently selling for
RM15.65.
What is our cost of equity?
Cost of Equity Example

Using SML:

Using DGM:
Exercise

Royan Industries decide to expand its


business and RM45,000,000 worth of
external funds need to be raised. One
alternative source of financing is to sell
common stock at RM50. At present the firm’s
growth rate is 6%. The dividend yield is 4%
and there is no floatation cost.
What is the cost of common stock for Royan
Industries?
Exercise
Dynamic Corporation needs RM3.2 million for its long term
expansion projects. As the Financial Manager of the company, you
are required to evaluate the costs of the following financing
alternatives:
◦ Issue common stock. The price of the existing shares of the company is
RM35. The expected dividend for next year is RM3.30 and the growth
rate will remain at 4 percent. The floatation cost is 5 percent of the
issue price.
◦ Issue 8 percent coupon interest bond of 10 years. The market price of a
similar bond is RM950. The floatation cost is 4 percent of the par value
of RM 1000. The current tax bracket of the firm is 10 percent.
◦ Issue a 12 percent preferred stock with a par value of RM100. The
floatation cost is 2.5 percent of the par value and the market price is
RM135.
Calculate the cost of each alternative and choose the best
alternative.
Example 1:
Megah Bhd plans to increase fixed assets by RM 5 million
by the end of the year. The present capital structure is
considered optimum and is follows:

6% bond, RM35 million


7% preferred stock, RM25 million
Common stock, RM40 million

New securities can be issued as follows:


⚫ 20 years, 7% bond, interest to be paid annually for
RM930 less floatation cost of 4%
⚫ 80% preferred stock to be sold at par
⚫ Common stock for RM90 flotation cost of 8%

The corporate tax rate is 45%. The company paid dividend


of RM6 last year and the expected growth is 7%. Calculate
cost of financing for each types of financing.
SOLUTION:
Step 1: Calculate each cost of capital
a. 20 years, 7% bond, interest to be paid annually for
RM930 less floatation cost of 4%
Kb = C/m + (PV – (MP- FC)
nxm a
PV + (MP-FC)
2
= 70 + (1000 – (930 – 40)
20 a
1000 + (930 – 40)
2
= 7.98%

Kb (after tax) = kb (1 - tax rate)


= 7.98% (1-0.45)
= 4.39%
b. 80% preferred stock to be sold at par
D1 = D0 (1 + g) Kps = Dividend a
= 6 (1+0.07) Current Market Price or Par Value -FC

Kps = 6.42
80
= 8.03%
D1 = D0 (1+g)
= 6 (1+0.07)
c. Common stock for RM90 flotation cost of 8%
=6.42
FC = 8% x 90 = 7.2, D1 = 6.42, g = 7%
Kcs = 6.42 + 7%
90 – 7.2
= 14.75% Kcs = (D1 / P0 – FC) + g
END OF
CHAPTER 9
TQ…☺

You might also like