1. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Methods of Financing Lecture No. 49 Chapter 15 Contemporary Engineering Economics Copyright © 2016

2. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Chapter Opening Story Laredo Petroleum Holdings has approved a $1 billion capital budget for 2014, which will be funded from internally generated cash flow and borrowings from senior securities.  At issue: Because of the size of financing involved, the firm financing method will affect the firm’s capital structure, the cost of capital, and financial risk.

3. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Methods of Financing o Equity Financing o Capital is coming from either retained earnings or funds raised from an issuance of stock. o Debt Financing o Money raised through loans or by an issuance of bonds. o Capital Structure o Well managed firms establish a target capital structure and strive to maintain the debt ratio.

4. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Equity Financing Flotation (discount) costs – The expenses associated with issuing new securities Types of equity financing o Retained earnings o Common stock o Preferred stock Retained earnings Preferred stock Common stock

5. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Example 15.1: Equity Financing by Issuing Common Stock  Given: o Scientific Sports, Inc. (SSI) needs to finance $10 million to develop and produce a new metal golf driver. o Share price for the new stock offering = $28 o Floatation cost = 6% of the issue price  Find: How many shares must SSI sell to net $10 million?

6. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Solution o ( 0.06)($28)(X) = 1.68X o Sales proceeds − flotation cost = Net proceeds 28X − 1.68X =$10,000,000 26.32X = $10,000,000 X = 379,940 shares. 1.68(379,940) = $638,300

7. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Debt Financing Bond Financing: o May incur floatation cost o No partial payment of principal o Only interest is paid each year (or semi-annually). o The principal (face value) is paid in a lump sum when the bond matures. Term Loan: o May involve an equal repayment arrangement o May incur origination fee o Terms negotiated directly between the borrowing company and a financial institution Bond Term Loan

8. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Example 15.2: Debt Financing by Issuing Bonds  Given: Scientific Sports, Inc. (SSI) needs to finance $10 million by issuing a mortgage bond. o Face value = $1,000 o Market price = $985 o Coupon rate = 12% interest payable annually o Floatation cost = 1.8% of the issue price  Find: (a) Number of bonds to be sold to net $10 million? (b) the total annual interest payment

9. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Solution (a ) To net $10 million, SSI would have to sell: $10,000,000/(1 − 0.018) = $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) = 10,339. (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.

10. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved 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.

11. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Example 15.3: Project Financing Based on an Optimal Capital Structure  Given: o SSI’s capital structure = 0.50 o Raise $5M by issuing common stock and $5M by issuing bonds at 12% interest. o Floatation cost Stock: 8.1% Bond: 3.2%  Find: Project cash flows o Project Description Life: 5 years Building: $3M Equipment: $6M Land: $1M Cash dividend: $2 per share Unit production cost: $50.31 Unit price: $250 Annual O&M cost: $600,000 Annual demand: 20,000 units Working capital: $500,000 Tax rate: 40%

12. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Solution