Lecture No. 49Chapter 15

Contemporary Engineering EconomicsCopyright © 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 FinancingEquity 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 FinancingFlotation (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

Example 15.1 Equity Financing by Issuing Common StockScientific Sports, Inc. (SSI) needs to finance $10 million to develop and produce a new metal golf driver.Share price for the new stock offering = $28Flotation cost = 6%of the issue priceQuestion: 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 = $10,000,000 26.32X = $10,000,000 X = 379,940 shares. 1.68(379,940) = $638,300

Debt FinancingBond 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

Contemporary Engineering Economics, 5th edition, © 2010

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 annuallyFloatation cost = 1.8% of the issue priceQuestion: (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/(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.

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