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JRM
RN 11.26.2013
Debt financing
Equity financing
Hybrid financing: Preference shares, leasing, options, warrants, and convertibles
Introduction
Based on the module on financial forecasting, in order to support an increase in assets, we can either resort to internal
financing or external financing. Let us look once more at the formula which we adapted to compute how much more a
company must raise by issuing debt or new stocks for any increase in assets or investments.
EFN =
Assets
Sales
x Sales (P)
Spontaneous Liabilities
Sales
x Sales (P)
PM
x Projected Sales
x (1- d)
Where:
Sales (P)
Spontaneous Liabilities
PM
d
In this module, the increase in assets will be deemed a response to a proposal to invest and not only a change to support
operation demands. At the same time, the focus will be on external financing and hybrid financing.
ASSETS
ASSETS
INCREASE
in ASSETS
(supported
by
operations)
INCREASE
in ASSETS
(supported
by external
financing)
LIABILITIES
CURRENT
LIABILITIES
LONG-TERM
LIABILITIES
OffBalance
Sheet
Financing
CAPITAL
RETAINED
EARNINGS
ORDINARY
SHARES
PREFERENCE
SHARES
Dependent
on
Retention
Ratio
Proportionate
to Sales
Issuances of
Straight debt
securities
Issuances of new
ordinary shares
Issuances of:
INCREASE
in ASSETS
(supported
by hybrid
financing)
Issuances of:
Convertibles
With
Warrants
APIC
changes:
Warrants
Outstanding,
Conversion
Privileges
Preference
Shares
Convertibles
With
Warrants
Debt financing
Benefits and drawbacks of debt
The following are advantages of issuing debt securities:
1. interest payments are tax deductible to a firm
2. wise use of debt may lower a firms weighted average cost of capital (WACC)
3. during inflation, debt agreements charging a fixed rate is repaid with cheaper pesos
The following are disadvantages of issuing debt securities:
1. interest and principal must always be met when due, regardless of a firms financial position
Leasing
Principal Payment
Interest Payment +
Aside from the availability of funds and stability of income generation, other factors affecting dividend policy are as
follows:
1. Legal Rules
4. Desire for Control
2. Cash Position of the Firm
5. Tax Position of Shareholders
3. Access to Capital Markets
External Equity Financing: Ordinary Shares
Valuation of Securities: Basic
The value of the stock is simply the present value of all the securitys future cash flows, as shown below:
Present Value of future cash flows related to stocks = Dividends1
(or Current Stock Issue Price)
(1+ks)1
P0
ks = D1/P0 + g
= D1/( ks g)
However this model can readily be used only in pricing single growth rate or one-stage growth stocks. The situation is: not
all common stocks grow perpetually at the same rate. Common stock dividends can actually vary. With non-constant
growth stocks, additional steps will have to be done before the DCF model above can be applied as is.
Valuation of Securities: Pricing Issues on Non-Constant Growth Stocks
Let us look into the following problem on pricing non-constant growth stocks.
Last year, Firm A paid P4.00 in annual dividends. This year, a ten percent increase is expected. What if there is an expected
return from common shares in the amount of 12%, and that the dividends are expected to grow by 10% per year for the next
two years, after which the dividends shall move steadily at 5%, at how much should the stocks be sold initially this year?
Using a time line, let us plot how the events are expected to occur:
g = 10%
Year 0
D0 = 4.40
g = 10%
1
g = 5%
2
g = 5%
3
g = 5%
4
.
5
0
D0 = 4.40
g = 10%
1
D1 = 4.84
g = 5%
2
D2 = 5.32
g = 5%
g = 5%
3
4
D3 = 5.59 D4 = 5.87
5
D5 = 6.16
6
D6 = 6.47
0
D0 = 4.40
g = 10%
1
D1 = 4.84
g = 5%
2
D2 = 5.32
g = 5%
g = 5%
3
4
D3 = 5.59 D4 = 5.87
5
D5 = 6.16
6
D6 = 6.47
Step 3: Compute for the present values of the Future Cash flows, since this will approximate the value of the stock, which in
turn is used to establish its price. Use the ks as the discounting rate.
g = 10%
0
D0 = 4.40
g = 10%
1
D1 = 4.84
g = 5%
2
D2 = 5.32
g = 5%
g = 5%
3
4
D3 = 5.59 D4 = 5.87
5
D5 = 6.16
6
D6 = 6.47
CF1=?
????
????
0
D0 = 4.40
g = 10%
1
D1 = 4.84
g = 5%
2
D2 = 5.32
g = 5%
g = 5%
3
4
D3 = 5.59 D4 = 5.87
5
D5 = 6.16
6
D6 = 6.47
0.8929
CF1=4.32
????
????
b. Expected Cash flow at horizon date (or simply, {Expected dividends at horizon date + price of the stocks at horizon
date}) The stocks price at horizon date is equal to the expected future cash flows starting that day onwards.
g = 10%
0
D0 = 4.40
D1=4.32
g = 10%
1
D1 = 4.84
g = 5%
2
D2 = 5.32
g = 5%
g = 5%
3
4
D3 = 5.59 D4 = 5.87
5
D5 = 6.16
6
D6 = 6.47
0.8929
????
To substitute,
P2 =
g = 10%
0
D0 = 4.40
P2 =
CF2 =
D2 + 1
0.12 -0.05
g = 10%
1
D1 = 4.84
= P 5.59
0.07
g = 5%
2
D2 = 5.32
0.8929
CF1=4.32
P2 =79.86
g = 5%
g = 5%
3
4
D3 = 5.59 D4 = 5.87
5
D5 = 6.16
6
D6 = 6.47
0.7972
CF2 =85.18
Step 4: Compute for the PRICE OF THE STOCK at Year 0 by adding the present values of the Future Cash flows.
g = 10%
0
D0 = 4.40
g = 10%
1
D1 = 4.84
g = 5%
2
D2 = 5.32
g = 5%
g = 5%
3
4
D3 = 5.59 D4 = 5.87
5
D5 = 6.16
6
D6 = 6.47
0.8929
CF1=
4.32
CF2=
67.91
CF2=72.23
0.7972
P2 =79.86
CF2 =85.18
Note to the Candidate: What if for example, the question is to compute for the price of the stocks at end of Year 1, instead
of Year 0, can you now compute for the stocks price?(0.12(5.32/ (0.12-0.05)-0.05)) = P 76
Summary of Points on Non-constant growth stocks:
To find the value of a stock with non-constant growth, follow these four steps:
1. Partition the dividend stream into a beginning period of non-constant growth followed by a period of permanent
constant growth.
2. Find the present value of the dividends during the period of non-constant growth.
3. Find the expected value of the stock at the end of the non-constant growth period (the beginning of the constant growth
phase), and then find the present value.
4. Add these two components to determine the present value of the stock, P o.
Valuation of Securities: Price-Earnings Model
Price-Earnings ratio is in substance the reciprocal of return on investment. Given a P/E ratio at a respective point in time
and predicting the EPS will allow estimation of stocks price:
Stock split
Stock Repurchases
Effect On
Number of Outstanding
Stock Price
Shares
Increase
Lower, though increasing
slightly immediately after
split
Lower
Increase
Lower
Increase
None
Contractual obligations
Claim to assets in
bankruptcy
Lowest
Highest claim
Preference Shares1
Limited rights when
dividends are
missed
Must receive before
ordinary
shareholders
After creditors
Cost of distribution
Highest
Lowest
Moderate
Moderate risk,
Moderate return
Not deductible
Tax- deductible
Not deductible
Leasing
The process by which a firm can obtain the use of certain fixed assets for which it must make a series of contractual,
periodic, tax deductible payments.
Potential benefits from leasing
1. Firm need not to have to borrow or use its liquid resources to purchase the asset
2. Provisions of a lease obligation may be less restrictive than a bond indenture
3. There may be no down payment requirement (generally required when purchasing an asset).
4. Firm avoids cost of obsolescence.
Types of Leases
1. Capital Lease (or Financing Lease):
a. a purchase rather than a lease
b. firm actually buys the property
c. must be shown on a firms balance sheet
d. examples include: oil drilling equipment and airplanes
2.
Operating Lease:
a. a conventional rental agreement
b. firm doesnt expect to own property
a) is not shown on a firms balance sheet
b) examples include: automobiles and office equipment
Convertibles
A conversion feature is an option included as part of either a bond or preferred stocks issue and allows its holder to change
the security into a specific number of shares of common stocks.
Convertibles usually have a call feature of convertibles allowing issuers to retire or force conversion paying a call price to
holders usually lower by 10 to 15% than the conversion value of the security. Convertibles that cannot be forced into
conversion are known as overhanging issue.
Ideally, the cost of convertibles are lesser than that of straight equity, but higher than straight debt. (kd < kc < ke )
Valuation of convertibles
Naturally, convertibles can be sold higher than straight securities.
Primary purchasers are corporate investors, insurance companies, and pension funds; Primary issuers are public utility
companies, acquiring firms, and firms experiencing losses.
Uses of warrants:
1. Enhances a debt issue by allowing for the issuance of debt under difficult circumstances
2. May be included as an add-on in a merger or acquisition agreement
3. Can be issued in a corporate reorganization or bankruptcy to offer shareholders a chance to recover some of their
investment
4. Traditionally has been associated with speculative real estate companies, airlines, and conglomerates
Valuation of warrants
Naturally, securities with warrants can be sold higher than straight securities.