joxc-TERM FINANCING DECISIONS ing objectives: sis that the stadents be able; Le the basic concepts of long-term financing decisions, 1 Kei fond the basi tos of capital structure management : the diferent factors influencing capital structure decisions, row the effects of operating leverage and financial leverage on capital structure + Kgowhow to determine optimal capital structure and its inporiance, ‘ hhow to incorporate capital structure into capital bud it < tad pital budgeting and the weighted average 1. apply te concept of time value of money and its importance, Introduction [As we have discussed in capital budgeting, different factors and tools were used to evaluate a | project whether suc project should be accepted. Once a certain project has been accepted or approved, | another problem or issue that the company must resolve is the funding, The company must also | evaluate the best source of such fund which refers to the so-called long-term financing decisions. Long- term financing decision entails not only the total cost of such fund but will affect the capital structure of the firm, Capital Structure is the Changing the capital structure will and this will affect nd is also the choice of a capital structure, which is equally an important decision as capital budgeting, Basic Concept and Objective of Capital Structure The concept or theory of capital structure | Cost of capital is the ek at or the price of the . The total cost of capital that will be incurred by the firm will be definitely basic objective of capital structure decisions is . This appropriate mix is called ‘tat will minimize the firm’s overall cost of capital. mal capital structure is the one that strikes the ae 4k. This could also be defined as the mix Coptel Structure Policy ital structure policy. cp sy nen i ot sce tal structure policy involves a tracts the a tends to lower the stock's price, but the nix the permanent sources of funds in a The objecti it ent is to . eRe e anayecmmen A Se cso ey structure actually exists or ‘actually owever, there are arguments whether an optimal capi‘Chepter 10 Long-Term Financing Decisions ———————______—28 affect its valuation and its cost of achieved, ‘The issue was focused on whether a firm can, in reality, capital by varying the mixture ofthe funds used. The firm mst analyze frst severl factors efor i target capital structure trying to have it as the optimal capit time to time depending on several economic conditions, though, most com structure as part ofthe firm's capital structure policy. These factors are: ctors before it can establish or before it can decide on the | structure. This target may change from panies set a specific capital 1, Business risk- is defined as the n es or ‘on equity (ROE), assuming the firm uses no debt. The firm's asset structure is the primary its business risk, Business risk varies from industry to industry and also among firms in lusty and may change overtime. Business risk is the residual effets ofthe company's a b “ Some ofthe most comnuon factors afjecting busines risk ae: * Demand variability - if the demand for products or services are stable, holding all other factors the same, the lower the business risk. * Sales price variability - ifthe products or services are sold in a highly volatile market, the ‘more the firm is exposed to business risk. + Input price variability - if the firm's costs of production (input) are highly uncertain or unstable, the higher its business risk. * Ability to adjust output prices for changes in input prices - itis the relative ability of the firm to change selling prices in relation tothe changes in their costs of production. + Degree of operating leverage of the firm or the extent to which costs are fixed. This relates to the cost structure ofthe firm, to which the higher the fixed cost components of the firm the higher the business risk. 2. Financial risk - is the additional risk placed on the common stock. It is the portion of the stockholders’ risk, over and above basic business risk, resulting from the use of financial leverage. Financial leverage is the extent to which fixed-income securities (debt and preferred stock) are used in a firm’s capital structure. Financial risk can be identified by its two key attributes: (1) the added risk of insolvency assumed by the common stockholder when the frm chooses to use financial leverage; (2) the increased variability in the stream of earnings available to the firm's common stockholders. Effects on taxes (income taxes) - Interest is a deductible expense, and deductions from income subject to income taxes usually make the difference in deciding capital structure, The higher the firm's tax rate, the use of debt capital is preferred. Though, on some point where the expected cost of default is large enough to outweigh the tax shield advantage of debt financing, turing tocommon equity financing is justifiable.254 5 ibility - the ability of the firm to raise capi Financial flexibility - the ability rm to raise capital on reasonable terms under difficult times OF ae ae Manager ‘must always have in mind while business cputoos are at its best ey a maintain an adequate reserve for internally financing i ations an future plans for expansions. Further, finance officers ie foal cofcapital is necessary for stable operations; that when money is tight inthe economy, or when a fim is experiencing some operating dfcltes, suppliers of capi companies with good financial positon pliers of capital prefer to advance funds to 4 ‘Management capabilities to forecast market conditions - It makes sense for financial managers to be familiar withthe business cycle because financial market and product market conditions can change abruptly during the cycle. This means that company policies and decisions may differ ‘over different phases (say expansion or contraction) of the cycle. Financial managers usually favor the use of internally generated equity in funding capital budgets : asic Tools of Capital Structure Management Just like in capital budgeting process, the management has to understand the following terms before it can finally evaluate an appropriate capital structure, These are: financial structure, leverage, and cost of capital. Financial struchure Financial structure is the mix of items on the right-hand side of the firm's balance sheet or its {otal liabilities and equity section. Total financial structure less total current liabilities equals total capital Suture. Since capital structure is about sources of funds, understanding the firms financial structure is owing the major components or sources of funds; from shorter financing or from long-term (debs and equity). However, this chapter will fcus on capital structure and how management accountants use it in every fund sourcing decision- making, leerge Leverage is the cost structure, in which the fixed costs represent a risk to the firm. Leverage is composed of the operating leverage and financial leverage. og COpeating leweage is used to measure operating risk, whch refers fo the Sed pert costs. Operating leverage is the use of fixed operating costs in the firm's cost structure, ‘When operating leverage is present, any percentage fluctuation in sales will result in a greater percentage fluctuation in earings before interest and taxes (EBIT). Operating ness ofa firm's EBIT to fluctuation in seles. Operating leverage leverage isthe responsiv resull when fined operating costs ae present in the firm's cost structure. Aegree of operating hchangein EBIT leverage fromthe * DOLs ~ “9 angen als base sales evel Yachange fui costae aatble the degre of operating vege (OOH) an bemessred PY pol, = 2?) a-w-F(fee ane eg If an analytical income statement is the only information available, the following formula is used: c before fixed costs DOL, = venue before eed cose = ts EBIT Al these formulas will provide the same results. Implications of operating leverage 1. Ateach point above the break-even level, the degree of operating leverage decrease, 2. Atthe break-even level of sales, the degree of operating leverage is undefined, 3. Operating leverage is present when the percentage change in EBIT divided by the percentage change in sales is greater than one. 4. The degree of operating leverage is attributed tothe business risk that a firm faces, . Financial leverage is used to measure of financial risk, which refers to financing a Portion of the firm's assets, bearing fixed financing charges, such as the interest ‘expense in debt financing. Financial leverage is also financing a portion of the firm's assets with securities bearing a fixed (limited) rate of return, such as the use of preferred stock. The higher the financial leverage, the higher the financial risk, and the higher the cost of capital Tp determine if financial leverage has been used to benefit the common shareholder, the focus Will be on the responsiveness of the company's earnings per share (EPS) to changes in is EBIT. ‘The firm is using financial leverage and the owners are exposed to financial rk wi change in EBS = is greater than 1.00 A measure of the firms use of financial leverage is as follows: degree of financial = _Ychange in EPS leverage fiom the = DFLayr = %change in EPS. base EBIT level % change in EBIT 1. The degree of financial leverage concept can be either in the positive or negative direction, 2. The greater the degree of financial leverage, the greater the fluctuations in EPS. A simple way to measure financial leverage is DFLo = —EBIT_ EBIT—I ‘where Tis the sum of all fixed financing costs © Combining Operating and Financial Leverage we Changes in es cause greater chan; IT. Ifthe firm chooses to financial leverage, ‘Combining operating and financial leverage causesence ly Combined leverage (DCL) can be expressed as degree of combined seh leverage fromthe = = Yochangein EPS vasessbskvel ®t change in sakes iibeDCLs eval to 40 mes then 1% change in sales wil resultina 4% cangein EPS, “Another way to compute DCL is with the following equation: DeL, = —QP=V) a QP-V)-F-T Degre of combined leverages the produto the two independent leverage measures. Ths: DCls = (DOLs) x (OFLean) Implications of combining operating and financial leverage 1, Total risk can be managed by combining operating and financial leverage in different degrees. 2 Knowledge of the various leverage measures helps to determine the proper level of overall risk that should be accepted. Toillustate computation of leverage The following is an analytical income statement for Leverage Firm, Inc. Sales 150,000, Variable costs 90,000 Revenue before fixed costs P 66,000 Fixed costs 35,000 EBIT P 25,000 Interest expense 10,000 Earnings before taxes P 15,000 Taxes (34) — 5,100 Net income E290 4. Calculate the degree of operating leverage (DOL) at this output b. Calculate the degree of financial leverage (DFL) at this level of EBIT. What is the degree of combined leverage (DCL)? Solutions 2 DOL at P150,000 sales level = P60,000/P25,000 = 2.4 times b.DFL at P25,000 EBIT eh 5/750 - PD = 167s © DCL AT P150,000 sales level = 24% 1.67 = 4.01 times\Ghapter 10 Long-Term Financing Decisions $54 Cost of capital Cost of capital is defined as the rate of return that is necessary to maintain the market Value the firm (or ae oF the firms stock). It is also called the abinr required me of return used to ‘measure and evaluate capital budgeting, capital structure, leasing ary and even the short financing decisions. In long-term financing decisions, cost of capital is the firm's weighted Average of the costs of debt and equity funds. Equity funds include both capital pee hand mera earings ig also desired or target rate of return used in the net present value iscounted cath flow ‘computations, Likewise, it is also defined as the minimum acceptable rate used in choosing. between projects employing the time-adjusted rate of return method. Concept of the Cost of Capital ‘The rate that must be earned in order to satisfy the required rate of return. The rate of return investment ‘which the price of a firm's common stock will remain unchanged. Investor's required metre bts etc pe dueto: a Interest payments on debt are tax deductible to the firm. b. rms incur expenses when issuing securities that reduce the proceeds to the firm, + Each type of capital used by the firm (debt, preferred stock, and common stock) should be incorporated into the cost of capital, with the relative importance of a particular source being based ‘on the percentage ofthe financing provided by each source of capital. * Using the cost of a single source of capital as the hurdle rate is tempting to management, particularly when an investment is financed entirely by debt. However, doing so is a mistake in logic and can cause problems. + A firm's weighted cost of capital isa function of 1. the individual costs of capita; 2, the capital structure mix; and 3._ the level of financing necessary to make the investment. Determining the Weighted Cost of Capital (WACC): Interest payments x (1 - Tax rate) 1. COSTOFDEBT = = ——__ Market Value of Debt (e.g, Bonds) Preferred dividends 2. COSTOF PREFERRED STOCK = Market Value of Preferred Stock Dividends on Common Stock 3. COST OF COMMONSTOCK = —___ sy Goren Market Valueof in Dividends Common Stock hesev ie Cost of (1 ~ Margi 4 cSTOFRETAINED EARNINGS = somnen + fa tebe Coot ‘company stockholders) rirm’scost of capital is = The weighted average of 1 to, multi 5 . vues of deb referred, common sock ad retain mailed Ay fe eh ator ng tepid tothe tia sures of pi Toi’ The XYZ. Corporation made available the following data for computing the firm's cost of ital: oi al interest payments on bonds payable Pena Prefered stock dividends AOD, Common stock dividends cat Annual growth in common stock dividend om Market values of Bonds payable om Common stock x00 Preferred stock as Retained earnings 100000 Company tax rate 30% Srockholders' marginal tax rate 7 Required: Calculate the firms cost of capital Solutions: 1. Costof Debt = P60,000x (130%) = 105% ‘P400,000 2. Cost of Preferred Stock = _ P2000. = — 100% 200,000 3. Cost of Common Stock = pmo +28 = 100% 1P300,000 = 30% 4. Costof Retained Earnings = ~—«10%x (1-704) 5 re th = ao (105% ) + 2044 10% ) +30 (1086 ) + 10H 3% ) = ‘Weight Factor Computation (capital structure) Weight of Debt - wastes > Fanaa SeeFCommon eck Freon / L000 = 10% Weight Of Retained Earningscom tame inl Cpt Sracture Using Leverage adCast of Cpt nusshlen OH are Asie they will be removed later. a ivi it. b THe company rakesa 10 percent vend payout : transaction costs are incurred. ; ‘wes E817, a Te ny fas aconsantearrngs befor interest and «a : Thecompany basa constant operating isk Given these assumptions, the firm is concerned with the following three rates: ven. aie (1) onthe firm's debt assuming perpetuity) computed as: 1 Ye— firm's debt where: Y = yield on the firm’s del l= anova rest charges 6g B= market value of debt outstanding . “ b. Required rate of return (ROE) or cost of common equity (assuming no earnings growth and 100% dividend payout ratio) computed as: EAC ROE = —— s where: ROE = required rate of retum on equity of the cost of common stock EAC = earmningsavailable to common stockholders S = market value of stock outstanding © Finm’s overall cost of capital (WACO) or the capitalization rate computed as EBIT wacc = —— v where: WACC = the firm's overall cost of capital (or the capitalization rate) EBIT = eamings before interest and taxes (ot operating income) V_ = B+ andisthe market value ofthe firm In determining ca ital structure, the concern is with what happens to these thee items cited “hrvewhen the ere of lveags as denoted ty he et eoy /3yra ' estate ample of Capit Sucre Analysis Using Leverage and Cost of Capital A. Using EBIT or the Net Operating Income In using EBIT, it suggests thatthe firm’s market value. ‘of debt and stock out increases, firm’s overall cost of capit i pital (WACC), and the value and the ing (V). are both independent ofthe degre to whichuses leverage. The key assumption with the use of EBIT is that WACC is constant reganiless of the ‘yee ete following data for 3} Corporation: is Payable, 5% interest rate Peo, "ows level of EBIT oe 20,000 “Assume that the cost of capital is constant at the rate of 10% tet ais the markt value ofthe fim? th Whats the ROR? cc. What is the debt/equity ratio? ution are Market value ofthe firm: EBIT 20,000 Visi ins eet orem wacc 10% b, Return on Equity (ROE) EAC = EBIT - 1 = 20,000 - (P60,000 x 5%) = P17,000 S =V-B = P200000 - P6000 = 140000 EAC P17,000 ROE = 2 = 1h s P140,000 b Debt/equity ratio B/S = 60,000 / P140,000 = 42.86% Let us assume that the company increases its debt from P60,000 to P100,000 and uses the proceeds to retire P100,000 worth of its common stock; assume that interest rate remains to be 5%. Determine the effect in its capital structure. @. Market value of the firm: EBIT +P20,000 Ve = — * moon WACC 10% 4 Return on Equity (ROE) EAC = EBIT - 1 = 20,000 - (P100,000 x 5%) = P15,000 S =V-B = 200,000 - P100,000 = P100,000 EAC 15,000 ROE=—— = —— = LR s 100,000 © Debt/equity ratio B/S = 100,000 / P100,000 = 1b(Chapter 10 Lone-Tem Financing Decisions tal remains constant (in this case 10%) Since using EBIT assumes that cost of capita : changes ‘in ievere, the cost of capital cannot ‘be altered through leverage. Therefore, Using se suggests that there is no one optimal capital structure: * aa suggests that both te overall cost of capital (WACC), and the mare yy, (Wo the firm are affected by the firm's use of leverage. The ely espn in asing ne inca veld (Y) and ROE remain unchanged asthe debuequity ratio increa ‘To illustrate: Using the same data from 3} Corporation, except that the required rate of aa (ROE) is 10%. Solution a. Market value of the firm LV. = Market value of stock outstanding (6) + Market value of debt outstanding (B) EAC = EBIT -1 = P20,000 - (P60,000 x 5%) = P17,000 EAC 17,000 $ -—— = ——= P7000 WACC 10% v= P170,000 + P60,000 = py30000 b. Overall cost of capital EBIT 20,000 WwACC = —— = —— = §20% v ‘230,000 c. Debt/equity ratio B/S = P60000 / PI7000 = + 3529% Same as above, let us assume thatthe company increases its debt from P60,000 to P1000 uses the proceeds to retire P100,000 worth of its common stock; i remains ot 5%. Determine the effect in its capital structure. ee at rmee ae a Market value of the firm V__ = Market value of stock outstanding (S) + Market value of debt outstanding (B) EAC = EBIT -1 = P20,000 - (100000 x 5%) = P1500y= P1so.000 + P100,000 = 250009 tp, Overall cost of capital EBIT ‘20,000 WO, ie oa = 50% ¢. Debi equity ratio B/S = PI00000 / PISI00 = g647% Notice that in this case, using the net income, the frm is able to increase its value, and lower its cos of capital as it increases the degree of leverage. Using the net income the frm could find an ‘optimal capital structure. A graph can be used to determine this capital structure. In financial rranagement courses, graphs are used to extremely detal this aspect. . Using the Traditional Approach (Moderate View Approach) In this approach, it assumes that there is an optimal capital structure where the firm can increase its value through leverage. It is basically combines the concept on the use of EBIT and NI in determining the value of the firm. Toillustrate: Again, use the data from 3] Corporation, except that the ROE is 12%, rather than 124% or 10%. ‘a. Market value of the firm V._ = Market value of stock outstanding (6) + Market value of debt outstanding (8) BAC = EBIT -1 = 20,000 - (P60,000 x 5%) = 17,000 EAC 17,000 ia tans 1 me PLOT WACC 12% V.= P170,000 + P60,000 = PAOLSsr . Overall cost of capital EBT = P2000 wacc = —— = —— 7 oe v 201,667State 10 Lo Tom asc ans $$ . Debt/equity ratio B/S = P60,000 / PI41,667 = 42.35% Same as in the first two approaches above, let us assume that the company increases its dey from P60,000 to P100,000 and uses the proceeds to retire P100,000 worth of its common assume further that interes rate now is 6% and that ROE at that degree of leverage is 14%. Determine the eas {nits capital structure. a. Market value of the firm V__ = Market value of stock outstanding (6) + Market value of debt outstanding (B) EAC = EBIT -1 = P20,000 - (P100,000 x 6%) = 14,000 EAC 14,000 S =—— = = P100,000 WACC 14% v= P100000 + P100,000 = P200000 D. Overall cost of capital EBIT P2000 wacc = _— = 100% v 200,000 © Debt/equity ratio B/S = P100,000 / 100,000 = 10% Note that the value of the firm is lower and its cost of capital is little higher than when the debt is P60,000. This result is due to the increase in ROE and increase in cost of debt. ‘These could mean that the optimal capital stracture occurs before the debt/equity ratio equals 100%, This again ‘ould be figured out through the use of graphs, D. The EBIT-EPS Analysis Using financial leverage will generate two effects on the earnings that will stream to the firm's ‘common stockholders: These ae: 1 ‘An increased risk in EPS due to the use of fixed financial charges. This effect has been ‘measured as previously discussed 2 A change in the level of EPS at a given EBIT associated with a specifi ca ital structure. This effect could be measured using the EBIT-EPS analysis, " EBIT-EFS analysis will help financial managers evaluate al Iterative financing plans analyzing the effect on EPS over a range of EBIT levels. Its main obmrns Cee objective is to determine thea int, The EBIT-EPS inliference point is the level of E T that will equate EI ii lan ultimately chosen from a set of two alternatives, The indiferece ae tains the i meative financing plans can be determined by solving for EBIT in the following equation: ay ceor-H(t-) -PD (BIT -1) 1-)- PD oe S S ere t= taxrate wie" pp. = preferred stock dividends P and Se = number of shares of common stock outstanding after financing for plan 1 and plan 2, respectively Tolllustrate ‘A, Assume tat Sitshu Enterprises is financed entirely with 3 million shares of common stock selling fecP20 share. Capital of PS million is needed for this year’s capital budget. Additional funds can be raised with new stock (ignore dilution) or with 13% 10-year bonds, The tax rate is 40%. Required: Calculate the financing plan's EBIT indifference point. Solutions ‘Alternative 1: Raising P4,000,000 worth of funds using stock will raise the number of shares to 320000 Alternative 2: Raising the funds from bonds will retain the number of shares but will have a fined charges of P520,000 (P4,000,000 x 13%). Indifference point is calculated as: (EBIT-0)(1-0.4) (EBIT -520,000)(1 - 0.4) 3,200,000 shares. 3,000,000 shares. for = pe320.000 nO re illic I tly approved the 'n Chef, Ine. has a present capital of P5 million worth of common stock. It recently app: on of special then equipment. “The financial officer is evaluating the possible sources of He dgtlble to the frm; (1 issue 40,000 shares of common ‘stock at P50; @) issuing preferred stock at i me Tate; Q)selling bonds at 10% for the entire amount needed. At present, the firm's current ‘2x rate is 50% and 100,000 shares outstanding. "sind ' Compute the EPS a a projected level of 1000000 EBIT assuming the use of all common all ot all preferred. ine the indifference point.ae ‘Common Preferred Stock Debt ‘Stock 1,000,000 | 1,000,000 | _P1,000,000 | EBIT | 200,000 0 Interest charges Eamings before taxes 7rp0000| 800,000 | 1,000,000 Treome tax 500,000 400,000 | 500,000 | Earnings aftr tax 500,000} 400,000 | 500,000 Preferred Stock dividend 0 | 160,000 500,000. 400,000 340,000 140,000 100,000 | _100,000 357 4.00 3.40 ‘Earnings available to common. ‘Number of common shares EPS. Indifference points willbe computed separately using (a) all common versus all debt and (2) al, common versus all preferred stocks. 1. All common versus all debt GeIT-Ha-)-PD BIT -1)1-#)-PD (EBIT-0)(1-0.5) —(EBIT - 200,000)(1 - 0.5) “Yomostars —”——*to0mb0stares SET ae ena an aK st EBIT = P700,000 2. Allcommon versus all preferred stock (BIT -1)(-t)- PD (@r-na-1)-PD ——- t 0-9) (BIT -0)¢1-05) - P160,000 ct a te sen diog 100,00 shares ean) = 50% OMEBTT = pana a) - Psa 000 Bor = Pulzago Based on these computations, we can conclude that: 4. Atany level of EBIT above P700,000, siuaon vill beothervse n/n bet han common toc. I EBT blow,b At alevel of EBIT above P1,120,00, pref ; lower, common stock isa bene peli eal is better than common; likewise if itis & Atany level of EBT, debts batter than prefered sc that is because of tax shield Reciew Problems changed due to the capital structure change? equity changed due to the capital structure change? of capital after the capital structure change? 3)_ By what percent has the cost of common. 4) What will be the composite cost lutions a. Value of firm = (600,000)(P40) = P20,000,000 b.Costofequity = 1/8 = 0135 EPS= 40/8 = P50 Netoperating income = —_P5,00 (500,000) = P2,500,000 © Market value of debt and equity 20,000,000 Market value of debt 5,000,000 Market value of equity 15,000,000 Net operating income P2500,000 Less interest expense 500,000 Earnings available to common stockholders 2,000,000 Note that P5 million of debt retires 125,000 shares of common stock at P40 per share. Thus, 375,000 shares remain. (1) EPS = P2,000,000/375,000 = P5.33. Dividend per share = P5.33 (2) P0.33/P5,00 = .066 or an increase of 6.6% @) Cost of common equity = P5.33/P40-0.1333 (0:1333 -0.125)/0.125 =0 066 or an increase of 6.6% 4) Composite cost of common equity = P2,500,000/P20,000,000 = 0.125 8. As the financial manager for a manufacturing frm, you have constructed the following partial pro- forma income statement forthe next fiscal year.‘tat 10Lon- Tam ncn Dacsong Sales P11,200,000 Variable costs 5,600,000 Revenue before fixed costs 5,600,000 Fixed costs 200,000 EBIT P 3,200,000 Interest expenses 1,600,000 Earnings before taxes P 1,600,000 Taxes (40%) 640,000 Net income 260,000 Required: a. What is the degree of operating leverage at this level of output? b, What is the degree of financial leverage? c. What is the degree of combined leverage? d, What is the break-even point in sales dollars for the firm? e. Ifthe average unit cost is P8, what is the break-even point in units? Solutions a. Degree of operating leverage = P5,600,000/P3,200,000 - 1 b. Degree of financial leverage = P3,200,000/ (P3,200,000 - P1,600,000) = 20 c. Combined leverage (operating and financial leverage) =1.75 = 2.00 = 350 d. Breakeven point in sales = P2,400,000/(1-0.5) = 4,800,000 CMR = 50% e. Breakeven point in units = P4800,000 / P8 = 600,000 units