08 Long Term Financing PDF

Chapter 8: Long Term Financing FIN 420 Financial Management by Fareiny Morni  Chapter Content 1. Types – Bonds, Preferred Shares and Common Stock 2. Characteristics of Bonds, Preferred Shares and Stock 3. Advantages and disadvantages of these instrume...

Chapter 8: Long Term Financing FIN 420 Financial Management by Fareiny Morni  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 FIN 420 Financial Management by Fareiny Morni 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 FIN 420 Financial Management by Fareiny Morni 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. FIN 420 Financial Management by Fareiny Morni Introduction Or should I Should I use capital borrow? instead? FIN 420 Financial Management by Fareiny Morni 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? FIN 420 Financial Management by Fareiny Morni 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 FIN 420 Financial Management by Fareiny Morni 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. FIN 420 Financial Management by Fareiny Morni  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. FIN 420 Financial Management by Fareiny Morni Types of Debt Term Loans Bond Long-term Debt FIN 420 Financial Management by Fareiny Morni 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. FIN 420 Financial Management by Fareiny Morni 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. FIN 420 Financial Management by Fareiny Morni Bond Characteristics/ Features Par Value Coupon Interest Rate Yield to Maturity Call Provision Bond Ratings Bond Maturities FIN 420 Financial Management by Fareiny Morni Bond Characteristics/ Features Par Value – The stated face value of the bond, usually RM1,000. Coupon/Interest Rate – Percentage of par value of the bond that will paid out periodically to the bondholders in the form of interest payments. – Interest payment can be paid annually or semi annually. – ie: PV = RM1000, 8% interest/coupon rate, maturity date = 10 years – Coupon/interest payment = 8% x RM1000 = RM80/2 = RM40 Bond Characteristics/ Features Yield to Maturity (YTM) – The rate the bondholder would earn if they bought the bond, held it until maturity and reinvested the interest earned. Call Provision – Gives the issuing firm the right to call-in the bond before maturity. FIN 420 Financial Management by Fareiny Morni Bond Characteristics/ Features Bond Ratings – Serve as a qualitative guide to the probability of default. Bond Maturities – The date on which the par value of the bond is to be repaid to the bondholders. – Maturities generally vary from five to forty years. FIN 420 Financial Management by Fareiny Morni Bond Categories Bond Categories Secured Unsecured Bonds Issued Subordina Zero Convertibl with Indexed Debentur tes Income Coupon e Bonds Stock Bonds es Debentur Bonds Bonds Purchase e Warrants FIN 420 Financial Management by Fareiny Morni Secured Bonds Convertible Bonds – Bonds that may be exchanged for shares of common stock. Bonds issued with Stock Purchase Warrants – Similar to convertible bonds; allows the holder to buy the stock at some agreed upon fixed prices. FIN 420 Financial Management by Fareiny Morni Secured Bonds Indexed Bonds – Bonds that have interest rates pegged to some price index. Zero Coupon Bonds – Bonds sold at deep-discount below par value. – There are no cash outlays for interest or principal payments until maturity. FIN 420 Financial Management by Fareiny Morni Unsecured Bonds Debentures – Long-term claims issued by credit worthy companies that is not secured by any specific assets of the company. Subordinated Debenture – Also known as junior debt; entitles the bondholder to get settlement after all senior creditors are paid in case of liquidation. Income Bonds – Pay interest only when the firm earns enough profits to pay interest. FIN 420 Financial Management by Fareiny Morni Bond Valuation Present Value = CP (PVIFAk,n) + M (PVIFk,n) of Bond, B0 Where: CP Coupon payment M Maturity Value k Discount rate or rate of return n Period to maturity FIN 420 Financial Management by Fareiny Morni 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%. Interest rate = 12% Coupon payment = interest rate x par value = 12% x RM1 000 = RM 120 N = 10 years Market Price = RM 950 Issuing cost = 5% M = RM1 000 Workings Present Value of Bond, B0 = CP (PVIFAk,n) + M (PVIFk,n) = 120(PVIFA12%,10)+ 1,000(PVIF12%,10) = RM1,000 FIN 420 Financial Management by Fareiny Morni Exercise KUAT Public Utilities issued a bond that pays RM80 annual interest with RM1,000 par value. It matures in 20 years. The required rate of return is 7 percent. i. Calculate the value of the bond. ii. How does the value change if the required rate of return increases to 10 percent? iii. Assume that the bond matures in 10 years instead of 20 years. Recompute your answers in (ii). FIN 420 Financial Management by Fareiny Morni Workings (i) Interest @ CP = RM80 N = 20 years K = 7% M = RM 1 000 Bo = 80 (PVIFA 7%, 20) + 1000 (PVIF 7%, 20) = 80 (10.594) + 1000 (0.2584) = RM 1 105.12 Workings (ii) Interest @ CP = RM80 N = 20 years K = 10% M = RM 1 000 Bo = 80 (PVIFA 10%, 20) + 1000 (PVIF 10%, 20) = 80 (8.5136) + 1000 (0.1486) = RM 829.69 Workings (iii) Interest @ CP = RM80 N = 10 years K = 10% M = RM 1 000 Bo = 80 (PVIFA 10%, 10) + 1000 (PVIF 10%, 10) = 80 (6.1446) + 1000 (0.3855) = RM 877.07 Exercise Lets assume that you purchased a 10-year bond with 14% coupon. The interest is paid semi-annually and assumes that the par value is RM1,000. – If the required rate of return on bonds of this risk and maturity is 14%, what will the bond sell for? – Lets assume that one year has passed and the bond is now a 9-year old bond, what would be the bond’s value if the required rate of return were 8%, 14%, and 20% respectively?  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. FIN 420 Financial Management by Fareiny Morni Cost of Debt or Bond Cost of Debt before Tax, Kdb = C + PV – (SP – FC) ( ) N PV + (SP – FC) 2 Cost of Debt, Kd = Kdb (1 – T) Where: C Coupon payment PV Par Value of Bond SP Selling Price of Bond FC Fixed Cost N Period to maturity FIN 420 Financial Management by Fareiny Morni 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%. Assume the tax rate is 40%. FIN 420 Financial Management by Fareiny Morni Workings Cost of Debt before Tax, Kdb = 120 + 1,000 – (950 – 50) ( ) 10 1,000 + (950 – 50) 2 = 13.68% Cost of Debt, Kd = Kdb (1 – T) = 13.68 ( 1- 0.4) = 8.21% FIN 420 Financial Management by Fareiny Morni 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 issue a 7% bond that will mature in 10 years. The firm is planning to sell the bonds at 6% discount. The current tax bracket of the firm is 30%. What is the cost of bond? FIN 420 Financial Management by Fareiny Morni Essential Points on Bonds 1. Whenever the going rate of interest or yield to maturity (YTM) is equal to the coupon rate, a bond will sell at its par value. 2. Whenever the YTM is above the coupon rate, a bond will sell below its par value. 3. Whenever the YTM is below the coupon rate, a bond will sell above its par value. FIN 420 Financial Management by Fareiny Morni Essential Points on Bonds 4. An increase in interest rates will cause the prices of outstanding bonds to fall, while a decrease in rates will cause the prices of outstanding bonds to rise. 5. The market value of a bond will approach its par value as its maturity date approaches. FIN 420 Financial Management by Fareiny Morni 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. FIN 420 Financial Management by Fareiny Morni Cost of Preferred Stock After-tax cost of Preferred Stock, KPS = DPS (P0 – F) Selling Price of the Preferred Stock, P0 = DPS KPS Where: DPS Preferred Shares Dividend P0 Selling Price of Preferred Shares F Floatation Cost FIN 420 Financial Management by Fareiny Morni Illustration 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. What is the after-tax cost of the preferred issues? FIN 420 Financial Management by Fareiny Morni Workings After-tax Cost of Preferred Stock, KPS = DPS (P0 – F) = (100 x 10%) 98 – 5 = 10.75% Selling Price of Preferred Stock, P0 = DPS KPS = (100 x 10%) 0.1075 = RM93.02 FIN 420 Financial Management by Fareiny Morni 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 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. What is the cost of preferred stock? FIN 420 Financial Management by Fareiny Morni 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. FIN 420 Financial Management by Fareiny Morni 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 FIN 420 Financial Management by Fareiny Morni The Dividend Growth Model Approach Start with the dividend growth model formula and rearrange to solve for RE FIN 420 Financial Management by Fareiny Morni 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? FIN 420 Financial Management by Fareiny Morni 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,  FIN 420 Financial Management by Fareiny Morni 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? 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. FIN 420 Financial Management by Fareiny Morni 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? Using SML: Using DGM: FIN 420 Financial Management by Fareiny Morni 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? FIN 420 Financial Management by Fareiny Morni Cost of Capital The firm needs to look at its cost of capital before venturing into any project. This cost is correlated with the share price of the firm. If the rate of return on investment is higher than the cost of capital, the share price will increase and vice versa. FIN 420 Financial Management by Fareiny Morni The Weighted Average Cost of Capital The firm’s weighted cost of capital is a composition of the individual costs of financing, weighted by the percentage of financing provided by each source. The firm’s weighted cost of capital is a function of: – The individual cost of capital – The makeup of the capital structure – the percentage of funds provided by debt, preferred stock and common stock. FIN 420 Financial Management by Fareiny Morni The Weighted Average Cost of Capital WAC = ∑ (% of total capital structure supplied by each C type of capital) x (cost of capital for each source of capital) FIN 420 Financial Management by Fareiny Morni Illustration Megah Manufacturing plans to increase fixed assets by RM 5 million by the end of the year. The present capital structure is considered optimum and is as follows: – 6% bond, RM 35 million – 7% preferred stock, RM 25 million – Common stock, RM 40 million New securities can be issued as follows: – 20 years, 7% bond, interest to be paid annually for RM 930 less floatation cost of 4%. – 8% preferred stock to be sold at par. – Common stock for RM 90 less floatation cost of 8%. The corporate tax rate is 45%. The company paid dividend of RM 6 last year and the expected growth is 7%. What is the weighted average cost of capital of FIN 420 Financial Management by financing the investment? Fareiny Morni 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. FIN 420 Financial Management by Fareiny Morni Exercise Below is the current capital structure for Suk Berhad: Bonds RM20 million Preferred Shares RM15 million Currently the firm is planning to expand their operations to accommodate increasing Common Stock RM50 million market demands. As a financial consultant you are requested to review the three alternatives which they have been presented with: – Issue bonds with a selling price of RM1,200 at 9 percent interest annually. The bonds will mature in 10 years and the issuance cost is RM35. – Issue 7 percent preferred shares at RM95 per share with a par value of RM100. The floatation cost is 8 percent of selling price. – Issue common stock of RM50 per share with a dividend yield of 6 percent. The company’s growth rate is at 7 percent and tax rate is 30 percent. You are required to determine the company’s: – After tax cost of bond. – After tax cost of preferred stock. – After tax cost of equity. Which is the best source of financing would you recommend to Suk Kedirik Berhad. What is the weighted average cost of capital for Suk Kedirik Berhad if the firm would like to maintain its current capital structure? FIN 420 Financial Management by Fareiny Morni References 1. Financial Management by Rohani A. Ghani and Mohd Sabri Hj Mohd Amin, InED, UiTM Shah Alam. FIN 420 Financial Management by Fareiny Morni Any questions End of Chapter 8 FIN 420 Financial Management by Fareiny Morni