Contemporary Engineering Economics, 4th edition, © 2007

Methods of Financing

Lecture No. 60Chapter 15Contemporary Engineering EconomicsCopyright © 2006

Contemporary Engineering Economics, 4th edition, © 2007

Chapter Opening Story – Hotels Go to the Mattresses Marriott International

plans to launch a major initiative to replace nearly every bed in seven of its chains.

Total estimated cost: $190 million

Issue: How to find a way to finance this large-scale project?

Contemporary Engineering Economics, 4th edition, © 2007

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

Capital Structure

Debt

Equity

Contemporary Engineering Economics, 4th edition, © 2007

Equity Financing

Flotation (discount) Costs: the expenses associated with issuing new securities

Types of Equity Financing: Retained earnings Common stock Preferred stock

Retained earnings

Preferred stock

Common stock

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Contemporary Engineering Economics, 4th edition, © 2007

Example 15.1 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, 4th edition, © 2007

• Issue: Raise net $10 million• Stock price: $28 per share• Flotation cost: 6% of the stock price, or $1.68 per share• Question: How many shares to issue?

(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

Flotation Cost

Contemporary Engineering Economics, 4th edition, © 2007

Debt Financing Bond Financing:

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:

Involve an equal repayment arrangement.

May incur origination fee Terms negotiated directly between the

borrowing company and a financial institution

Bond Financing

Term Loans

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Contemporary Engineering Economics, 4th edition, © 2007

Example 15.2 Debt Financing (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 $1,000bond would be sold at $985, a 1.5% discount, the total number of

bonds to be sold would be

$10,183,300/($985) = 10,338.38.

(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, 4th edition, © 2007

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.