SOURCES OF INTERMEDIATE AND LONG-TERM FINANCING: DEBT AND EQUITY TERM LOANS

The principal sources of funds may be broken into these general categories:  1 to 10 years maturity
 Repaid in periodic instalments
1. External:
 Secured by a chattel mortgage or mortgage on real property
 Debt
 May be obtained from private commercial banks, insurance
 Equity
institutions, government controlled banks and agencies such as GSIS,
 Hybrid
DBP and so on.
2. Internal:
 Operations BONDS or LONG-TERM DEBT

Indenture- is the legal agreement between the issuing firm and the bond
DEBT FINANCING
trustee who represents the bondholders.

ADVANTAGES DISADVANTAGES In the case of insolvency, the claims of debt are honoured before those of both
Indenture ordinary and preference shares.
provisions may
limit the firm's Classification of Long-term Debt or Bonds:
Tax Deductible
future financial 1. Debenture Bonds- unsecured loan to the company.
flexibility
2. Subordinated Debentures- claims are only honored only after the claims of
Financial Obligations are
secured debt and unsubordinated debentures have been satisfied.
Obligation is set by contract
clearly specified and must be 3. Mortgage Bonds- debt instruments accompanied by a pledge of property
(except floating met by the issuing firm. Subclassification of mortgage bonds include the following:
rate bonds)
In inflationary Debt may  First Mortgage Bonds- Bondholders have senior claims on the secured
economy, debt depress the asset.
may be paid back market values of  Second Mortgage Bonds- bondholders have second claim on assets
with "cheaper outstanding and are serviced only after the claims of the first mortgage bonds have
pesos" ordinary shares been satisfied.
 Blanket or general mortgage bonds- all the assets of the firm act as
CATEGORIES OF SOURCES OF FINANCING: security.
(On the basis of maturity)  Closed-end mortgage bonds- issuing firm is forbidden to use the same
assets given as security for this issue to secure future mortgage bonds of
1. SHORT-TERM- 1 year or less the same priority.
2. INTERMEDIATE- More than 1 year to 10 years  Open-end mortgage bonds- do not preclude the issuance of additional
3. LONG-TERM- longer than 10 years mortgage bond of the same priority that uses the same secured asset
as security.
  Limited open-end mortgage bond- hybrid of the open-end and closed- RETAINED EARNINGS
end mortgage bonds. They allow the issuance of additional bonds at
Earnings available after the payment of interest, taxes and preference share
the same priority level using the already mortgaged assets as security
dividends may be used to either pay ordinary, cash dividends or be plowed
but only up to a limited amount.
back into the company in the form of additional capital investment.
4. Floating Rate or Variable Rate Bond- These instruments pay interest initially
at about 1% above the Treasury bill rate. The rate is allowed to float after
an initial 3 to 18 months guaranteed minimum interest rate. CAPITAL-STRUCTURE MANAGEMENT

-aims to mix the permanent sources of funds used by the firm in a manner that
will maximize the company’s ordinary share price or to search for the funds mix
EQUITY FINANCING
that will minimize the firm’s cost of composite capital.
Ordinary Shares

The major equity sources of capital for long-term investment in the firm come
BASIC TOOLS OF CAPITAL STRUCTURE MANAGEMENT
from ordinary shares and retained earnings.
When a firm expands, it needs capital, and that capital can come from debt
ADVANTAGES DISADVANTAGES
or equity. Basically, capital structure involves a trade-off between risk and
Does not oblige Cost of underwriting
return. The optimal capital structure strikes a balance between these risk and
the firm to make and distributing
return effects. Furthermore, if the source of long-term capital is limited, there
payments to ordinary shares are
shareholders usually higher than may be a need for management to place a constraint or absolute limit on the
preference share and size of the firm’s capital budget during a particular period. This is known as
debt. Capital Rationing or Optimal Capital Budget Determination.

BASIC APPROACH IN ESTABLISHING THE OPTIMAL CAPITAL BUDGET

Dividends on ordinary The basic procedures involved in establishing the optimal capital budget are:
Carries no fixed shares are not tax
maturity date deductible 1. Prepare the Investment Opportunity Schedule (IOS)- ranked in order of IRR
Sale of ordinary If the firm has more 2. Prepare the Marginal Cost of Capital (MCC)- showing WACC
shares provide equity than called for 3. Prepare the graph that combines the IOS and MCC
additional cushions in its capital capital 4. Determine the Retained Earning’s breakpoint. (RE/Equity Fraction)- point
to creditors against structure, the where marginal cost of capital increases
losses average cost of 5. Determine NPV using risk-adjusted cost of capital.
capital will be higher 6. Accept all independent projects that have rates of return in excess of the
than necessary. cost of the capital, and reject all others.
ILLUSTRATIVE CASE: CAPITAL RATIONING ILLUSTRATIVE CASE: COST OF CAPITAL DETERMINATION

The Clear Glass Company uses a process of capital rationing in its decision
The following tabulation gives earnings per share (EPS) figure for the Magic
making. The firm’s cost of capital is 13%. It will only invest 60 million this year. It
Company during the preceding 5 years. The firm’s ordinary share, 7.8M
has determined that the internal rate of return for each of the following
outstanding is now selling for P65 and the expected dividend at the end of the
projects:
current year (2010) is 55% of the 2009 EPS. Investors expect EPS growth rate to
continue.
PROJECT PROJECT SIZE INTERNAL RATE OF RETURN
Year EPS
A 10M 15.0%
2009 5.73
B 30M 14.0%
2010 6.19
C 25M 16.5%
2011 6.68
D 10M 17.0%
2012 7.22
E 10M 23.0%
2013 7.80
F 20M 11.0%
The current interest rate on new debt is 9%. The firm’s marginal tax rate is 32%.
G 15M 16.0%
Its capital structure, considered to be optimal, is as follows:

Required:
Debt P104M
1. Determine the projects that the firm should accept.
Equity 156M
Total 260M
2. If projects D and E are mutually exclusive, how would that affect your overall
answer? That is which projects would you accept in spending the 60M?
Required:
1. Calculate Magic’s after-tax cost of new debt and of ordinary equity,
assuming that the new equity comes only from retained earnings.

2. What is the firm’s weighted average cost of capital, assuming that no new
ordinary share is sold and that debt costs 9%?

3. How much can be spent on capital investments before external equity

(ordinary shares) must be sold?

4. What is the firm’s weighted average cost of capital if new ordinary shares
can be sold to the public at P65 per share to net the firm P58.50 per share? The
cost of debt is constant.

 NEXT MEETING: EFFECT OF OPERATING LEVERAGE AND FINANCIAL

LEVERAGE ON CAPITAL STRUCTURE