ES 40: Engineering Economy Topic 4: Capital Financing

Capital Financing
Methods of Financing
Funds for financing an engineering or business enterprise maybe
classified into: (1) equity, (2) borrowed or debt capital. Equity capital
is owed by the investors in the enterprise and they expect to earn profit
from their investment. However, there is no obligation to pay them when
there is no profit. When funds are borrowed, the borrower is supposed to
pay interest and to repay the principal on a specific date, whether or not
the operations of the enterprise have been profitable or not. Loans are
fixed obligations, and failure to repay them on time usually leads to
embarrassment.

Types of Business Organizations

1. Individual Ownership – is the simplest form of business organization,
wherein the business is owned entirely by one person who is
responsible for its operation. All profits that are obtained from the
business are his alone, but he must also bear all losses should they
incurred.
Advantages of the individual ownership. The owner of a single
proprietorship enjoys the following advantages:
 It is easy to organize. It is subject to fewer legal restrictions than
the other types of business organizations.
 The sole owner has full possession of all the profits that accrue to
the business. He does not have to share the profits with anyone.
 Full control of the business resides under one owner. Nobody else
is consulted as to affairs of the business.
 It is flexible because it is not necessary to request permission
from the government for the performance of any legal act.
 The affairs of the business are free from the scrutiny of anyone
except owner himself. All affairs of the organization maybe kept
secret.
Disadvantages of the individual ownership. The points to consider
against a sole proprietorship are the following:
 It is difficult to raise large amounts of capital in forming or
expanding the business.
 It is relatively difficult for the owner to obtain long-term loans,
because of the uncertainty of the life of the enterprise
 The life of the organization depends on the life of the owner. In
case of his death the business has to be entirely reorganized by
his heirs.
 The sole owner has no partners whom he can consult in deciding
important matters.
 The most important and critical disadvantages is the unlimited
liability of the owner for his debts, in case of bankruptcy. The sole
owner’s liabilities do not end with his investment in the business,
but even extend to his own personal properties.

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ES 40: Engineering Economy Topic 4: Capital Financing

2. Partnership – is an association of two or more persons for the purpose

of engaging in business for profit.
Advantages of a partnership. Some of the advantages enjoyed by
the partners are the following:
 Two or more persons with different talents or abilities may group
together for their common welfare. An engineer may associate
with a capable salesman, and together the business may be
more successful that if owned
 More capital maybe obtained by the partners pooling their
resources together.
 It is relatively easy to form compared to the formation of a
corporation.
 The partners directly share in the profits and this is an incentive
for them to exert their best for their common benefit.
 It is also a flexible form of organization, without the need for
permission from anyone in the pursuance of legal acts.
Disadvantages of the partnership. The partnership form of
business organization has some serious disadvantages. These are:
 The amount of capital is definitely limited by the resources of the
partners.
 It is difficult to obtain capital in large amounts particularly
through long-term loans.
 The life of the partnership is limited to the lives of the partners.
In case one of the partners dies or ceases to be connected with
the enterprise for any other reason, the business has to be
reorganized.
 The partners may have serious disagreements among
themselves, which may end the partnership.
 In cases where the partners have equal or nearly equal shares in
the business, there is usually divided authority.
 At least one of the partners is liable for all the liabilities of the
enterprise in case of bankruptcy. This is the most serious
disadvantage.

3. Corporation – is a distinct legal entity, separate from the individuals

who own it, and which can engage in practically any business
transaction which a real person could do. It is considered the most
important type of business organization and may have perpetual life if
desired. Since it is a legal entity, it may sue or be sued in its own
name.
Advantages of the corporation. Some of the advantages of a
corporation over the sole proprietorship or the partnership are the
following:
 It enjoys perpetual life. The corporation does not die with the
death of any one member or even of all the members.
 The stockholders of the corporation are only liable to the extent
of their investment. In case of bankruptcy, the personal
properties of any stockholder cannot be attached by the creditors
to pay for the debts of the corporation. This is the most important
advantage.
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ES 40: Engineering Economy Topic 4: Capital Financing

 It is relatively easier to obtain large amounts of money for its

expansion, due its perpetual life and non-dependence on the
lives of the stockholders.
 The ownership in the corporation is readily transferred.
 The best managerial talent is obtained by the hiring of
competent executives.
Disadvantages of the corporation. Some of the disadvantages of a
corporation are the following:
 The activities of a corporation are limited to those stated in its
charter.
 It is relatively complicated in formation and administration.
 There is a greater degree of governmental control as compared
to other types of business organizations.
 Due to the manipulations of the controlling stockholders the
minority stockholders are sometimes exploited.
 Double taxation. The corporation pays an income tax on its
earnings. Furthermore, when its net income is distributed to the
owners in the form of cash dividends, these dividends are
considered personal income of the stockholders and are again
subject to tax.

Capitalization of a Corporation
The capital of a corporation is acquired through the sale of stock.
There are two principal types of capital stock.

Common Stock represents the ownership of stockholders who have

a residual claim on the assets of the corporation after all other claims
have been settled. No return is guaranteed on the investment of common
stockholders.
Common stockholders, as owners of the corporation, have certain
legal rights, among which are the following:
1. To call and hold meetings, usually upon the request of a majority
of the stockholders.
2. To vote at stockholders’ meetings.
3. To elect the members of the board of directors who will manage
the affairs of the corporation.
4. To amend the charter of the corporation subject to government
approval.
5. To prepare and amend the by-laws of the corporation.
6. To receive dividends when such are declared.
7. To share the remaining assets, if any, when the corporation is
dissolved.

Preferred stock also represents ownership, and it possesses the

same rights as common stock, but in addition, it enjoys certain
preferences, not possessed by common stock. In case the corporation is
dissolved, the assets must be used to satisfy the claims of the preferred
stockholders before those of the holders of the common stock. Preferred
stockholders usually have right to vote in meetings, but not always.

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ES 40: Engineering Economy Topic 4: Capital Financing

Financing with Bonds

A bond is essentially a long-term note given to the lender by the
borrower, stipulating the terms of repayment and other conditions. In
return for the money loaned, the corporation promises to repay the loan
and interest upon it at s specified rate. Because the bond merely
represents corporate indebtedness, the bondholder has no voice in the
affairs of the business, at least for as long as the interest is paid, and of
course is not entitled to any share of the profits.
Bonds usually are issued in units of from P1,000 to P 5,000 each,
which is known as the face value, or par value, of the bond. This is to be
repaid to the lender at the end of a specified period of time. When the
face value has been repaid, the bond is said to have been retired or
redeemed. The interest rate quoted on the bond is called the bond rate,
and the periodic interest payment due is computed as the face value
times the bond interest rate per period.

Classification of Bond according to security provided for a bond.

1. Registered bonds. In all registered bonds, the owner’s name is

recorded in the books of the corporation, and interest is paid
periodically to the owners without their asking for it.
2. Coupon bonds. These are bonds to which are attached coupons
indicating the interest due and date when such interest is to be paid.
The owner of the bond can collect the interest due by surrendering the
same to the officers of the corporation or the same may be cashed at
specified banks.
According the security behind the bonds, the classification is as follows:
1. Mortgage bonds. These are bonds whose security is a mortgage
on certain specified
assets of the corporation. If the corporation fails to pay the bond
value at the date of maturity, title to the property is transferred to
the bondholders, who may take possession and sell the same to
reimburse the amounts they have invested.
2. Collateral Trust Bonds. In such types of bonds, the corporation
pledges securities which it owns, such as the stocks or bonds of one
of its subsidiaries. In case maturity the bondholders have to depend
on the assets of the subsidiary for redemption of their investment.
Usually however the issuing corporation includes a guaranty
involving its properties in order to enhance the value of the bond to
prospective investors.
3. Debenture bonds. These are bonds without any security behind
them except a promise to pay by the issuing corporation. Such
bonds may only be issued by large and well-known firms, whose
record of achievement is known to the public.

Methods of Bond Retirement

1. The corporation may issue another set of bonds equal to the amount of
bonds due to redemption.

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ES 40: Engineering Economy Topic 4: Capital Financing

2. The corporation may set up a sinking fund into which periodic deposits
of equal amount are made. The accumulated amount in the sinking
fund is equal to the amount needed to retire the bonds at the time they
are due.

A = periodic deposit to the sinking fund

F = accumulated amount, the amount needed to retire the bond
i = rate of interest in the sinking fund
r = bond rate per period
I = interest on the bonds per period
A + I = total periodic expense F

0 1 2 3 4 n-1 n

A A A A A A
Bond retirement by sinking fund

A = = F ( A / F ,i %,n )
I = Fr

A + I = F ( A / F ,i %,n ) + Fr
Bond Value
The value of the bond is the present worth of all future amounts that
are expected to be received through ownership of the bond.

Let F = face, or par value

C = redemption or disposal price ( often equal to F )
r = bond rate per period
n = number of periods before redemption
i = investment rate or yield per period
P = value of the bond n periods before redemption
C

Fr Fr Fr Fr Fr Fr

0 1 2 3 4 n-1 n
Cash Flow for a bond investment

P = Fr( P/A, i%, n ) + C ( P/F, i%, n )

P = Fr
[ ( 1+i )n −1
( i+i )n i ] +C ( 1+i )−n

Sample Problems
1. A community wishes to purchase an existing utility valued at P 500,000
by selling 5% bonds that will mature in 30 years. The money to retire

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ES 40: Engineering Economy Topic 4: Capital Financing

the bonds will be raised by paying equal annual amounts into a sinking
fund that will earn 4%.What will be the total annual cost of the bonds
until they mature?*
2. To finance a public works program, a municipality will issue a 3.5%
sinking bonds, redeemable at par in 15 years with interest payable
annually. The sinking fund rate is 3% per annum. If it is estimated that
P 25000 can be raised annually through taxation to provide for the
interest payment and sinking deposit, what is the maximum face value
of the total bond issue? Assume bonds are sold at par*
3. A man was offered a Land Bank certificate with a face value of P
100,000 which is bearing interest of 8% per year payable semi-
annually and due in 6 years. If he wants to earn 6% semi-annually, how
much he pay the certificate?**
Methods of Solution (Remarks)
*Methods of bond retirement method
**Bond Value approach

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