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Principles of Finance

17.6 Alternative Sources of Funds

Principles of Finance17.6 Alternative Sources of Funds

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

By the end of this section, you will be able to:

  • Calculate the required return to preferred shareholders.
  • Calculate the WACC of a firm that issues preferred shares.
  • Discuss how issuing new equity impacts the cost of equity capital.
  • Explain the functionality of convertible debt.

A company can finance its assets in two ways: through debt financing and through equity financing. Thus far, we have treated these sources as two broad categories, each with a single cost of capital. In reality, a company may have different types of debt or equity, each with its own cost of capital. The same principle would apply: the WACC of the firm would be calculated using the weights of each of these types multiplied by the cost of that particular type of debt or equity capital.

Preferred Shares

Although our calculations of WACC thus far have assumed that companies finance their assets only through debt and common equity, we saw at the beginning of the chapter that the basic WACC formula is

WACC = D% × rd1-T + P% × rpfd + E% × reWACC = D% × rd1-T + P% × rpfd + E% × re

In addition to common stock, a company can raise equity capital by issuing preferred stock. Owners of preferred stock are promised a fixed dividend, which must be paid before any dividends can be paid to common stockholders.

In the order of claimants, preferred shareholders stand in line between bondholders and common shareholders. Bondholders are paid interest before preferred shareholders are paid annual dividends. Preferred shareholders are paid annual dividends before common shareholders are paid dividends. Should the company face bankruptcy, the same priority of claimants is followed in settling claims—first bondholders, then preferred stockholders, with common stockholders standing at the end of the line.

Preferred stock shares some characteristics with debt financing. It has a promised cash flow to its holders. Unlike common equity, the dividend on preferred stock is fixed and known. Also, there are consequences if those preferred dividends are not paid. Common shareholders cannot receive any dividends until preferred dividends are paid, and in some cases, preferred shareholders receive voting rights until they are paid the dividends that are due. However, preferred shareholders cannot force the company into bankruptcy as debt holders can. For tax and legal purposes, preferred stock is treated as equity.

The cost of the preferred equity capital is calculated using the formula

rpfd=DivpfdPpfdrpfd=DivpfdPpfd

Suppose that Greene Building Company has issued preferred stock that pays a dividend of $2.00 each year. If this preferred stock is selling for $21.80 per share, then the company’s cost of preferred stock is

rpfd = $2.00$21.80 = 9.17%rpfd = $2.00$21.80 = 9.17%

Think It Through

Calculating Common Equity Financing

Greene Building Company uses 40% debt, 15% preferred stock, and 45% common stock in its capital structure. The yield to maturity on the company’s bonds is 7.2%. The cost of preferred equity is 9.17%. In the most recent year, Greene paid a dividend of $3.15 to its common shareholders. This dividend has been growing at a rate of 3.0% per year, which is expected to continue in the future. The company’s common stock is trading for $32.25 per share. Greene pays a corporate tax rate of 21%. Estimate the WACC for Greene.

Issuing New Common Stock

An existing firm can acquire equity capital to expand its assets in two ways: the retention of earnings or the sale of new shares of stock. Thus far in the chapter, the cost of equity capital calculations have assumed that the earnings were being retained for equity capital financing.

The net income that is left after all expenses are paid is the residual income that belongs to the shareholders. Instead of receiving a fixed payment for letting the firm use their capital (like bondholders who receive fixed interest payments), the reward to shareholders for letting the company use their capital varies from year to year. In a good year, net income and the reward to shareholders is high. In a poor year, net income is low or perhaps even negative.

The net income can either be paid immediately and directly to shareholders in the form of dividends or be retained within the company to fund growth. Shareholders are willing to allow the company to retain these earnings because they expect that the money will be used to fund profitable projects, leading to an even larger reward for shareholders in future years.

Although managers do not need to actively solicit the funds that are retained to fund the business, managers cannot view these funds as costless. The shareholders will require a return on those funds to entice them to allow the company to delay paying the dollars to them immediately in terms of a dividend.

Suppose a company has $1 million in net income one year. If it pays $250,000 in dividends and retains $750,000, then it can finance $750,000 more in assets. If the company has a capital structure of 25% debt and 75% equity and wants to maintain that capital structure, it must increase its debt by $250,000 to balance the increase in equity. Thus, the company would be increasing its total financing by $1 million. Of that financing, 25% would be debt financing, and 75% would be equity financing.

To increase its assets by more than $1 million, the company would need to decide to either change its capital structure or issue new stock. Consider the firm represented by the market-value balance sheet in Figure 17.5. The firm has $900 million in assets. These assets are financed by $225 million in debt capital and $675 million in equity capital, resulting in a capital structure of 25% debt and 75% equity.

A Market-Value Balance Sheet for a Company with a capital structure of 25% debt and 75% equity. Since the company has $900,000,000 in Assets, its debt is $225,000,000 its Equity is $675,000,000. The rectangle representing debt is 25% of the size of the rectangle representing assets. The rectangle representing equity is 75% of the size of the rectangle representing assets.  Stacked together, they are the debt and equity rectangles are the same size as the asset rectangle.
Figure 17.5 Market-Value Balance Sheet for a Company with $900 Million in Assets and a Capital Structure of 25% Debt and 75% Equity

The retained earnings of $750,000 cause the equity on the balance sheet to increase to $675.75 million. The company could sell $250,000 in bonds, increasing its debt to $225.25 million. Figure 17.6 shows the impact on the balance sheet. The company has increased its financing by $1,000,000 and can expand assets by $1,000,000. The capital structure remains 25% debt and 75% equity.

A Market-Value Balance Sheet for the same company in Figure 17.5. Since the assets have increased by $1,000,000, the debt and equity need to increase in equal proportion. $250,000 is added to the previous debt of $225,000,000; new debt is now $225,250,000.  $750,000 is added to the previous retained earnings of $675,000,000; new retained earnings are now $675,750,000.  The rectangles representing debt and retained earnings are still 25% and 75% (respectively) of the size of the assets.  Together, the size of the rectangles representing debt and equities equal the size of the rectangle representing assets.
Figure 17.6 Balance Sheet with $1 Million Growth Financed through Retained Earnings and New Debt

What if the economy is in an expansionary period and this company thinks it has the opportunity to grow at a rate of 5%? The company knows that it will need more assets to be able to grow. If it needs 5% more assets, its assets will need to increase to $945 million. To increase the left-hand side of its balance sheet, the company will also need to increase the right-hand side of the balance sheet.

Where does the company get the $45 million in capital? With $750,000 in retained earnings, the company can increase its equity to $675.75 million, but if the remainder of $44.25 million was financed through debt, the company’s capital structure would change. Its weight of debt would increase to $225,000,000 + $44,250,000$945,000,000 = 0.2849=28.49%.$225,000,000 + $44,250,000$945,000,000 = 0.2849=28.49%.

If the company has determined that its optimal capital structure is 25% debt and 75% equity, financing the majority of the growth through debt would cause it to stray from these levels. Funding the growth while keeping the capital structure the same would require the firm to issue new shares. Figure 17.7 shows how the firm would need to finance $45 million in growth while maintaining its desirable capital structure. The firm would need to increase equity capital to $708.75 million; retained earnings could provide $750,000, but $33 million of new equity would need to be sold.

A Market-Value Balance Sheet for the same company in Figure 17.5. Since the assets have increased by $45,000,000, the debt and equity need to increase in equal proportion. $11,250,000 is added to the previous debt of $225,000,000; new debt is now $236,250,000.  $750,000 of retained earnings plus $33,000,000 in new equity is added to the previous retained earnings of $675,000,000; new equities are now $708,750,000.  The rectangles representing debt and retained earnings are still 25% and 75% (respectively) of the size of the assets.  Together, the size of the rectangles representing debt and equities equal the size of the rectangle representing assets
Figure 17.7 Balance Sheet with $45,000,000 in Financing Coming from Debt, Retained Earnings, and New Stock

Investors who are providing common equity financing require a return to entice them to let the company use their money. If this company has paid $0.50 per share in dividends to shareholders and this dividend is expected to increase by 3% each year, we can use the constant dividend growth model to estimate how much common shareholders require. If the stock is trading for $8.00 per share, the cost of common equity financing is estimated as

re = Div1P0 + g =$0.515$8 + 0.03 = 0.0644 + 0.03 = 0.0944 = 9.44%re = Div1P0 + g =$0.515$8 + 0.03 = 0.0644 + 0.03 = 0.0944 = 9.44%

If, however, the firm must issue more equity, its cost of equity for those additional shares will be higher than 9.44%. Even if shareholders are willing to pay $8.00 per share for the stock, the firm will incur flotation costs; this means the firm will not receive the entire $8.00 to use to finance new assets and generate a profit for shareholders. Flotation costs include the costs of filing with the Securities and Exchange Commission (SEC) as well as the fees paid to investment bankers to place the new shares.

When new equity must be issued to finance the company, the flotation costs must be subtracted from the price of the stock to determine the net proceeds the firm will receive. The cost of this new equity capital is calculated as

re - new = Div1P0-F + gre - new = Div1P0-F + g

where F represents the flotation costs of the new stock issue. If, in this example, the flotation cost is $0.25 per share, then the cost of raising new equity capital is

re - new = Div1P0-F + g = 0.515$8-0.25 + 0.03 = 0.0665 + 0.03 = 0.09 = 9.65%re - new = Div1P0-F + g = 0.515$8-0.25 + 0.03 = 0.0665 + 0.03 = 0.09 = 9.65%

Issuing new common equity is the most expensive form of raising capital. Equity capital is already expensive because the common shareholders are the residual claimants who will only be paid if all other claimants are paid. Because of this risk, they require a higher rate of return than providers of capital who have precedence in the order of claimants. Flotation costs must be added to this equity cost when new shares are issued to grow the company.

Think It Through

Cost of Issuing New Equity

You are a financial manager for American Motor Works (AMW). The target capital structure for the company is 30% debt and 70% equity. You know that your company’s after-tax cost of debt is 4.6%. Your company paid a dividend of $3 per share last year, and it has a policy of increasing its dividend at a rate of 1.5% each year. AMW stock is currently trading for $27.50 per share. You estimate that the company’s retained earnings will be $10 million this year. If the company needs to issue new shares of stock, flotation costs are expected to be $0.75 per share.

Given this information, you are tasked with calculating the company’s WACC. You need to provide an estimate of WACC if retained earnings are used and an estimate if new equity must be issued.

Convertible Debt

Some companies issue convertible bonds. These corporate bonds have a provision that gives the bondholder the option of converting each bond held into a fixed number of shares of common stock. The number of common shares the bondholder would receive for each bond is known as the conversion ratio.

Suppose that you own a convertible bond issued by Sheridan Sodas with a face value of $1,000 and a conversion ratio of 20 shares that matures today. If you convert the bond today, you will receive 20 shares of Sheridan common stock. If you do not convert, you will receive $1,000. If you convert, you are basically paying $1,000 for 20 shares of Sheridan stock. The conversion price is $1,00020 = $50.$1,00020 = $50. If Sheridan is trading for more than $50 per share, you would want to convert. If Sheridan is trading for less than $50 per share, you would not want to convert; you would prefer the $1,000. In other words, you will choose to convert whenever the stock price exceeds the conversion price at maturity.

A convertible bond gives the holder an option; the bondholder is able to choose between the face value cash or receiving shares of stock. Options always have a positive value to holders. It is always preferable to be able to choose $1,000 or shares of stock than to simply be given $1,000. There is a possibility that the shares of stock will be more valuable, and there is no way the choice can put you in a worse position.

Because holders of convertible bonds have the valuable option of conversion that holders of nonconvertible bonds do not have, convertible debt can be offered with a lower interest rate. It might seem as if the firm could lower its weighted average cost of capital by issuing convertible debt rather than nonconvertible debt. However, this is not the case. Remember that holders of convertible bonds choose whether they would prefer to convert the bond and become a stockholder or receive the face value of the bond at maturity.

If a bond has a face value of $1,000, the convertible bond holders will consider whether the stock they can convert to is worth more than $1,000. Only when the price of the stock has increased enough that the value of the stock received is more than $1,000 will the bondholders convert. However, this means that instead of paying $1,000, the firm is paying the bondholder in stock worth more than $1,000. In essence, the firm (and the current shareholders) would be selling an equity position in the company for less than the market price of that equity position. The lower interest rate compensates for the possibility that conversion will occur.

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