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FINANCING DECISIONS How to Finance Assets

FINANCING DECISIONS How to Finance Assets. Debt Instruments Mortgage Bonds - secured with real estate Chattel Bonds - secured with personal property Unsecured Debt Debentures- Backed by name only “Junk Bonds”- Very high risk, high yield Payment made on debt is interest.

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FINANCING DECISIONS How to Finance Assets

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  1. FINANCING DECISIONSHow to Finance Assets • Debt Instruments • Mortgage Bonds- secured with real estate • Chattel Bonds- secured with personal property • Unsecured Debt • Debentures- Backed by name only • “Junk Bonds”- Very high risk, high yield • Payment made on debt is interest

  2. FINANCING DECISIONS • Equity Securities- Shares of ownership in company • Common Stock • Voting rights • Price Volatile • Last to receive Value Created- dividends • Preferred Stock • Preference over common for dividends • no voting rights • higher yield than common

  3. FINANCING DECISION RULE FINANCING SHOULD RESULT IN MAXIMUM SHAREHOLDER VALUE To maximize value- maximize stock price To maximize Stock price- maximize EPS EPS = Net Income/ No. shares common stock outstanding

  4. MAXIMIZING FIRM VALUE Example- 1. Assume EPS = $3.00/Share 2. If Valuation multiple is 25, then Market Price is $75/Share 3. Multiply Shares Outstanding by Market Price (EG) 20,000,000 shares X $75/share = $1,500,000,000 4. If EPS rises to $4.00/share, then market value increases to 20,000,000 shares X $100/ share = $2,000,000,000 5.Share price is 25 x $4.00/share = $100/share

  5. EBIT-EPS ANALYSIS EBIT operating earnings LESS: INTEREST debt x int. rate NIBT pre-tax earnings LESS: TAX NIBT x tax rate NIAT NIBT-TAX LESS: P/S DIV. P/s X rate EARNINGS AVAIL. NIAT-P/S Div No. shares C/S O/S Earnings available/ CS OS = EPS Earnings per Share

  6. EBIT-EPS ANALYSIS EBIT $10000 Operating Earnings Less: Interest -1000 $20000x.05 NIBT 9000 EBIT-Interest Less: Tax - 4500 NIBT x .50 NIAT 4500 NIBT-TAX Less: P/S DIV -1500 NIAT-(PS x RATE) Earnings Available 3000 NIAT-P/S DIV =EPS $.30 NO. Shares C/S O/S 3000/ 10000

  7. EBIT-EPS EXAMPLE Current Structure EBIT $150000 LESS: INT ($250000X.10) -25000 NIBT 125000 LESS: TAX (.50) -62500 NIAT 62500 LESS: P/S DIV. -12500 EARNINGS AVAIL 50000 . No. shares C/S O/S 50000 =EPS $1/Share

  8. FINANCING NEW PROJECT 1. Project cost is $400000 2. Additional EBIT will be $200000 3. Tax rate is .50 4. Can finance with all debt at .06 or, 5. Issue 50000 new shares at $8/Share 6. Existing Capital Structure remains in place 7. Calculate EPS under each alternative 8. NO. SHARES O/S IS 50000 9. Pick Financing method with higher EPS

  9. FINANCING NEW PROJECT CURRENT DEBT COMMON EBIT $150000 $350000 $350000 -INT -25000 - 49000 - 25000 NIBT 125000 301000 325000 -TAX (.50) -62500-150500-162500 NIAT 62500 150500 162500 -P/S DIV -12500-12500-12500 EARN. AV 50000 138000 150000 / C/S O/S 50000 50000 100000 EPS $1/SH $2.76/SH $1.50/SH

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