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Contemporary Engineering Economics, 4 th edition, © 2007 Methods of Financing Lecture No. 60 Chapter 15 Contemporary Engineering Economics Copyright © 2006
Contemporary Engineering Economics, 4 th edition, © 2007 Chapter Opening Story – Hotels Go to the Mattresses Marriott International plans to launch a major initiative to replace nearly every bed in seven of its chains. Total estimated cost: $190 million Issue: How to find a way to finance this large-scale project?
Contemporary Engineering Economics, 4 th edition, © 2007 Methods of Financing Equity Financing – Capital is coming from either retained earnings or funds raised from an issuance of stock Debt Financing – Money raised through loans or by an issuance of bonds Capital Structure – Well managed firms establish a target capital structure and strive to maintain the debt ratio Capital Structure Debt Equity
Contemporary Engineering Economics, 4 th edition, © 2007 Equity Financing Flotation (discount) Costs: the expenses associated with issuing new securities Types of Equity Financing: Retained earnings Common stock Preferred stock Retained earnings Preferred stock Common stock + +
Contemporary Engineering Economics, 4 th edition, © 2007 Example 15.1 Issuing Common Stock Scientific Sports, Inc. (SSI) needs to finance $10 million to develop and produce a new metal golf driver. Share price for the new stock offering = $28 Flotation cost = 6% of the issue price Question: How many shares must SSI sell to net $10 million?
Contemporary Engineering Economics, 4 th edition, © 2007 Issue: Raise net $10 million Stock price: $28 per share Flotation cost: 6% of the stock price, or $1.68 per share Question: How many shares to issue? (0.06)($28)(X) = 1.68X Sales proceeds – flotation cost = Net proceeds 28X – 1.68X = $10,000, X = $10,000,000 X = 379,940 shares. 1.68(379,940) = $638,300 Flotation Cost
Contemporary Engineering Economics, 4 th edition, © 2007 Debt Financing Bond Financing: Incur flotation cost No partial payment of principal Only interest is paid each year (or semi-annually) The principal (face value) is paid in a lump sum when the bond matures Term Loan: Involve an equal repayment arrangement. May incur origination fee Terms negotiated directly between the borrowing company and a financial institution Bond Financing Term Loans +
Contemporary Engineering Economics, 4 th edition, © 2007 Example 15.2 Debt Financing (a) To net $10 million, SSI would have to sell $10,000,000/( ) = $10,183,300 worth of bonds and pay $183,300 in flotation costs. Since the $1,000 bond would be sold at $985, a 1.5% discount, the total number of bonds to be sold would be $10,183,300/($985) = 10, (b) For the bond financing, the annual interest is equal to $10,338,380 (0.12) = $1,240,606 Only the interest is paid each period, and thus the principal amount owed remains unchanged.
Contemporary Engineering Economics, 4 th edition, © 2007 Capital Structure (Debt Ratio) Definition: The means by which a firm is financed. Mixed Financing: Capital is raised by borrowing from financial institutions and by issuing stocks and/or using retained earnings. Target Capital Structure: Set a target debt ratio by considering both business risk and expected future earnings.
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