Lecture No. 49 Chapter 15 Contemporary Engineering Economics Copyright © 2010 Contemporary Engineering Economics, 5th edition, © 2010

Chapter Opening Story  Disney’s Shanghai Park Plan Advances  $3.59B investment in building a theme park in mainland China  Disney needs to find a way to finance this large scale project, if the project gets going.  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. Contemporary Engineering Economics, 5th edition, © 2010

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. Contemporary Engineering Economics, 5th edition, © 2010 Capital Structure Debt Equity

Equity Financing Flotation (discount) Costs: the expenses associated with issuing new securities Types of Equity Financing: Retained earnings Common stock Preferred stock Contemporary Engineering Economics, 5th edition, © 2010 Retained earnings Preferred stock Common stock

Example 15.1 Equity Financing by 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, 5th edition, © 2010 ( 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

Debt Financing Bond Financing: May 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: May involve an equal repayment arrangement. May incur origination fee Terms negotiated directly between the borrowing company and a financial institution C ontemporary Engineering Economics, 5th edition, © 2010 Bond Term Loan

Example 15.2 Debt Financing by Issuing Bonds  Scientific Sports, Inc. (SSI) needs to finance $10 million by issuing a mortgage bond.  Face value = $1,000  Market price = $985  Coupon rate = 12% interest payable annually  Floatation cost = 1.8% of the issue price  Question: (a) Number of bonds to be sold to net $10 million? (b) the total annual interest payment (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) = 10,339. (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. Contemporary Engineering Economics, 5th edition, © 2010

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. Contemporary Engineering Economics, 5th edition, © 2010

Example 15.3 Project Financing Based on an Optimal Capital Structure  SSI’s capital structure = 0.50  Raise $5M by issuing common stock and $5M by issuing bonds at 12% interest.  Floatation cost:  Stock: 8.1%  Bond: 3.2%  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% Contemporary Engineering Economics, 5th edition, © 2010