FINANCE MANAGEMENT FIN420 chp 9

Long-Term Financing Chapter 9

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The financial manager needs long-term sources of

financing to fund the purchase of long term assets.

Most companies do not have the amount of capital on

hand to fund such an asset. When internal funds are

not immediately available, the financial manager must

finance the project by issuing bonds, preferred stock

and common stock and plan to use the cash flows

generated by the project to pay off the financing.

Learning objectives

After learning this chapter, you should be able to:

1. Describe types of long-term financing available in the market

2. Distinguish their features

3. Compute the price of bond, stock and preferred stock

Long-Term Financing

GOAL

Chapter 9 Long-Term Financing

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9.0 INTRODUCTION Capital is a necessary element in production, without which the firm cannot operate. All firms

need to secure proper financing sources, from debt or equity, to support its operations

especially when involves in large capital expenditures. Proper financing mix will be able for

the firm to operate at an acceptable level of risk and the desired level of rate of return. This

in turn will ensure the firm as ability to (1) acquires additional funds with relative ease and (2)

maintains its stability and growth in the future.

The use of debt will results in a fixed obligation that need servicing regardless of the financial

conditions of the firm. Any failures to service the debt may eventually force the firm to

bankruptcy. The positive side is that the financing cost is generally cheaper than equity since

interest payments is tax deductible and may act as leverage to improve the firm's

profitability. Thus, the risk-return tradeoffs must be considered the firm could operate in

balance with acceptable level of returns and risks.

9.1 LONG-TERM DEBT

Debt represents a source of permanent financing used extensively to support capital

investment. There are varieties of long-term debt instruments: (1) convertible, or (2) straight

or non-convertible. Unlike straight debt instrument, convertible debt securities give the holder

the options to exchange the debt issue for a specified number of firm's common shares

during a specified period. Our focus in this section is on the straight loans that are not

convertible to equity. Common features for long-term debts are:

1. Fixed interest rate. The interests represent fixed obligations that must be service

when due, without fail. Currently, with the advance in financial markets there are

variable rates' securities available, especially term loan.

2. Fixed maturity date. The maturity date for debt instrument is fixed at which the

issuer must make the final payment to redeem the debt issue when it is due.

Failure to service the principal amount and/or the interest payments on schedule constitutes

default and the lenders have the right and can force the firm into bankruptcy. Therefore, the

use of debt in the financial structure relates to higher risk. There are several reasons why

companies prefer debt financing over equity financing:


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1. Management control. The management maintains that control over the company as

there in no dilution of ownership involves in the debt issue. In addition, the debt

holders do not participate in the company’s management and decision-making under

normal circumstances. However, bondholders have prior claim over equity holders in

case of bankruptcy.

2. Cost of funds. The cost of debt is cheaper compared to equity as interest paid to

debt holders are tax deductible, and thus reduced the tax liability and the actual costs

of using debt.

Certain debt issue carries a bullet maturity whereby the issuer have to repay the entire

principal amount one lump-sum at the end of the maturity date; while others carry provisions

for sinking fund in which the principal amount is paid in two or more redemption payments.

9.1.2 Term Loans

Term loans can be obtained in a short time, flexible, and low issuance costs

with maturity of more than 5 years. The sources of loans are from banks,

insurance company, or a pension fund. Term loans are amortized over the life

of the loan as shown in the previous section, and may have fixed or variable

interest rates.

9.1.3 Bonds

Bond is a long-term promissory note issued by a government or business unit

that obligates the issue to make periodic interest payments and the principal

payment at maturity date to the holder. The holder is a creditor to the

company and has priority claims on the company’s income and assets as

specified in the indenture. Indenture is the contractual agreement between

the firm and bondholders that specifies the right and responsibilities of both

parties. A trustee and the Securities and Exchange Commission see that

terms of the indenture are carried out. The following sections will focus on

bond characteristics or features and relevant issues in general.

Par Value

It is the stated face value of the bond, usually RM1,000 that represent the

amount of money borrowed by the firm and will be repaid at some future date

or maturity date. Number of bonds issued depends on the principal of the


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financing required. For example, with a principal of RM2 million there will be

2,000 bonds issued to the investors.

Coupon Interest Rate

Stated as the percentage of par value of the bond will be paid out periodically

to the bondholders in form of interest payments on the amount borrowed in

cash. The coupon attached to the bonds, which the holder can cash in for his

interest payments periodically. This associates with bearer bonds, which is

different from registered bonds. A coupon or interest payment is defined as

coupon rate times the par value. The interest payment can be paid annually

or semi annually. Bonds traditionally are issued at fixed rate of interest or

coupon, although there have been recent issues with variable interest rates.

Yield to Maturity (YTM)

Is the rate the bondholder would earn if you bought a bond, held it until

maturity, and reinvested the interest earned.

Call Provision

This provision gives the issuing firm the right to call-in the bond before

maturity. The company usually pays the bondholder an amount greater than

the bond's par value if the bond called. The additional amount is defined as a

call premium. A call provision serves two basis purposes for the firm.

a. A callable bond issue can be retired in an orderly manner, a little at a

time.

b. In cases when a firm believes that interest rate may be dropping in the

future. If the firm issues callable bonds, then should interest rates

drop, the firm would recall the outstanding bonds and reissue the debt

at some new lower interest level.

The required rates of return on bonds with a call provision tend to be higher

than similar bonds without a call provision.


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Bonds Ratings

Bonds are rated by rating's agencies (such as Moody's of Standard & Poor's,

Rating agency of Malaysia) before they are sold. Continues assessment is

made after issuance to monitor its rating throughout its maturity. These

ratings serve as a qualitative guide to the probability of default.

Bond Maturities

Maturity date is the date on which the par value of the bond is to be repaid to

the bondholders. Within two (2) months of issue in the market, bonds are

normally refers as “new issue”. maturities generally vary from five to forty

years, although most have historically been in the 20 to 30 year range. In the

last few years, however, there have been more bonds issued with shorter

maturities; this due to highly volatile market interest rates.

Coverage Ratios

It measures the firm's ability to meet interest and principal payments and thus

avoid default. This is one of the essential elements in the analysis of

corporate bonds, besides the times interest earned ratio (TIE) discussed

earlier. The fixed charge coverage ratio (FCC):

FCC = EBIT + Lease Payments [Interest + (Lease Payments) + (Sinking Fund Payment)] / (1 - T)

Restrictive Covenants

A restrictive covenant is a provision in a bond indenture or term loan

agreement that requires the issuer of the bond to meet certain stated

conditions. Typical provisions include requirements that debt not exceed a

specified percentage of total capital, that current ratio be maintained above a

specific level, that dividends not be paid on common stock unless earnings

are maintained at a given level and so on. Overall, these covenants are

designed to insure, as far as possible, that the firm does nothing is cause the

quality of the bonds to deteriorate after they are issued.


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Sinking funds

It is a provision specifying the principal repayments must be made before the

maturity date. The principal value is repaid in multiple installments, over the

life of the bond. If required by the bond indenture, it is mandatory for the

issuing firm retires portion of the bonds in orderly manner.

Conceptually, a bond represents a specific type of borrowing by a

corporation. For example, a 3-year bond at 10% coupon rate issued at par

involves the following cash flows for the issuer and the investor:

Year 0 1 2 3

Cash flows for issuer

1,000 – 100 – 100 – 100

– 1,000

Cash flows for investor

– 1,000 100 100 100

1,000

When a bond is first issued, the corporation receives the par value (principal)

of the bond from the purchasers less associated cost. Each year, the

company will pay interest to bond holders for the use of the money (coupon

payments). In addition, the company has to repay back the principal or par

value at maturity. Bonds can be classified as secured and unsecured.

Secured bonds

Most bond issues are on secured basis (mortgage bond) that is secured by a

lien on the company’s specific assets that has market value higher than the

bonds’ issue. Several bonds that fall into this category are:

1. Convertible Bonds. These bonds may be exchanged for shares of

common stock. The exchange price of the stock is fixed in the bond

agreement. This agreement offers the potential for capital gains to the

investor, while the issuing firm gets the advantage of lower coupon


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rates. In short, it is used as a "sweetener" to induce people to buy the

bonds.

2. Bonds Issued With Stock Purchase Warrants. This is similar to a

convertible bond; it allows the holder to buy stock at some agreed

upon fixed prices.

3. Indexed Bonds. These bonds have interest rates pegged to some

price index; that is, the interest rate rises when inflation rises and falls

when inflation falls. Floating rate bonds accomplish much the same

thing, but indexed bonds are considered a better inflation hedge.

4. Zero Coupon Bonds. These bonds are sold at deep-discount below

par value. There are no cash outlays for interest or principal payments

until maturity.

Unsecured bonds

Bonds are issued without a lien on the company’s specific asset, and

therefore bondholders will become general creditors to the company in case

of bankruptcy. Companies with strong and reputable financial standing and

earnings power are able to issue and attract investors to invest in this type of

bonds.

1. Debentures. Represent a long-term claims issued by credit-worthy

companies that is not secured by any specific assets of the company.

2. Subordinated debenture. It is also known as junior debt that entitles

the bondholder to get settlement after all senior creditors are paid in

case of liquidation. Therefore, the yield is higher than other type of

bonds to compensate for the higher risks incurred by the bondholders.

3. Income bonds. These bonds pay interest only when the firm earns

enough profits to pay interest. It is normally cumulative in nature that

limits to no more than three years.


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The cost of debt or Bond

The cost of long-term debt or borrowing is the cost at which the firm must pay

for the use of the funds. From the lender's point of view, it is the rate of return

required from their investment. Therefore, it represents the cost of borrowing

and the minimum rate of return that the firm must earn from capital

investment to cover the interest and principal payments. The following factors

are important to give due considerations in calculating the actual cost of

financing:

1. Net proceeds. Net proceeds are the issue price less cost of issuing. It

is the actual amount of funds available from the debt issue. Thus, the

actual cost must relate to the amount available that can be utilized.

2. After tax cost of debt. The cash flows from the capital investment

used in analysis are calculated on an after tax basis. Thus, it is

necessary to make the cost and benefits comparable on an after-tax

basis.

The explicit cost of debt is generally lower than equity due to:

1. Favorable tax treatment of interest expenses on debt and

2. Its priority in disposition of income from operations and assets in case

of liquidation.

The latter will ensure the safekeeping of lender's investment and thus,

requires lower returns compared to equity investors that do not enjoy the

same privileges. The most common debt instrument is bond, which typically

carries RM1,000 face value. It can be sold either at a discount (price less than

face value) or at a premium (price greater than face value). In addition, the

issuer will bear issuance expenses such as legal fees and brokerage fees

that will reduce the net proceed from the debt issue.

To illustrate, let assume that TM Afiq Inc., plans to issue RM1,000,000 of

bonds that have a face value of RM1,000 and an annual coupon interest of 12


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% for 10 years. Due to high interest rates, it can be sold for RM950 each with

issuance costs of 5 %. Thus, the net proceeds equal to:

Face value (M) 1,000

Less: Discount 1,000 – 950 50

Issuance cost 1,000(0.05) 50

Net proceeds (B0) 900

The after tax cost of debt, Kd is equal to Kdb (1 – T)

Where Kd : Before tax cost of debt

T : The firm's marginal tax rate

The calculation for before tax cost, Kd, is either by using; (1) a valuation

approach via discounted cash flow method that normally involves trial and

error and interpolation; or (2) a yield to maturity method.

Valuation approach. For the above example, Kdb using a discounted cash

flow method or valuation approach can be determined as follows

Before actually try to determine the before tax cost of debt, it is advisable to

understand several basic rule of thumb or relationship concerning the net

proceeds or present value, B0 of a bond and the before tax cost of a bond, Kb

as follows:

B0 = CP (PVIFAk,n) + M (PVIFk,n)

Where CP : The annual interest or coupon payment in Ringgit

M : The face or maturity value of the bond; normally at RM1,000

B0 : The net proceeds from the sale of the debt issue or the present

value of a bond

n : The period to maturity in years

k : The discount rate or the investor’s required rate of return

Also referred to as the before tax cost of a bond, Kd


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1. If the net proceeds equal to the face value, then the before tax cost

of a bond equals to coupon rate or a bond. Therefore, no calculation is

necessary to determine the Kb.

2. If the net proceeds are higher than the face value, the discount rate

or Kb should be lower than the coupon rate.

3. If the net proceeds are lower than the face value, discount rate or

Kb should be higher than the coupon rate.

To prove the first relationship, let the discount rate equals to 12%. The

present value of a bond equals:

At 12% B0 = 120 (PVIFA12%,10) + 1,000 (PVIF12%,10)

= 120 (5.6500) + 1,000 (0.3220)

= RM1,000

In our example or TMAfiq, the net proceeds are RM900 that is lower than the

face value of RM1,000. Therefore, the before tax costs, Kb is higher than the

coupon rate of 12%. Therefore, higher discount rate should be used to reduce

the value to RM900. Let the discount rate equals 14 %, then the present

value:

At 14% B0 = 120 (PVIFA14%,10) + 1,000(PVIF14%,10)

= 120 (5.2162) + 1,000 (0.2697)

= RM895.64

Since the actual proceeds from the debt issue are RM900, it shows that the

cost of debt lies between 12% (=RM1,000) and 14% (=RM895.64).

Interpolation is therefore, necessary to determine the before-tax cost, which

is:

Percent RM

12% 1,000.00

Kd 900.00

14% 895.64

Kd = 12% + (100 / 104.36)(14 – 12)

= 13.92%

100.00 104.36


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If the firm marginal tax rate is 40 %, the after-tax cost:

After tax Kd = 13.92% (1 – 0.40)

= 8.35%

The above calculations show that the marginal after-tax cost of debt for

TMAfiq is relatively low at 8.35%.

Yield to Maturity Approach (YTM). The Yield to Maturity represents an

estimate of the bondholder would earn if a bond is bought and held it until

maturity, and reinvested the interest earned periodically at the prevailing rate.

At the company’s point of view, this represents costs of using bonds to

finance the funds requirement. The approach utilizes the following formula to

determine the YTM:

YTM = Kd = (CP + (M – B0) / n) / (M + B0) / 2

Kd = (120 + (1,000 – 900) / 10) / (1,000 + 900) / 2

= 130 / 950

= 13.68%

After tax Kd = 13.68% (1 – 0.40)

= 8.21%

The yield to maturity is an approximation since it does not consider the time

value of money. Its after-tax cost of debt differs slightly to the discounted cash

flow method. For accuracy, the valuation approach should be used.

Interest Rate Risk on Bonds

As time passes and interest rates change, so will the required rate of return

on the bond. The bond's coupon rate cannot change; but since they are sold

on the secondary market, the selling price (and thus the yield to maturity) can

be adjusted to reflect the changes in the interest rates.

Since bonds offer a fixed stream of payments, the bond's price or value will

change with in interest rates. This means that the holders of bonds will find


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0

500

1000

1500

2000

2500

0% 5% 10% 15% 20%

Current rate

Bon

d va

lue 1-year

6-year

12-year

the value of their bonds changing as the interest rates change. The risk of

changing bond values due to change in interest rate called interest rate risk.

As is shown in the Table 9-1, the longer the maturity of a security, the greater

their prices change in response to a given change in interest rates. All the

bonds shown are 10% bonds with par values of RM1,000, the only difference

is in their maturities.

Table 9-1 Price Volatility of Bonds

Thus, we see that the longer the maturity of a bond, the more volatile is its

price with respect to changes in the interest rate. This volatility exists because

the investor is "locking" himself into a fixed stream of payments for a longer

period of time, while interest rate varies in the market.

To further illustrate the price movements of a bond, let assume that you

purchased a 10-year bond with 14% coupon. The interest is paid semi-

annually, and assumes that the par value is RM1,000. If the required rate of

return on bonds of this risk and maturity is 14% what will the bond sell for?

Current rate 1-year bond 6-year bond 12-year bond

0%

5%

10%

15%

20%

RM1,100.00

1,047.00

1,000.00

956.52

916.47

RM1,600.00

1,253.77

1,000.00

810.75

667.45

RM2,200.00

1,442.00

1,000.00

728.97

556.00


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B0 = 70 (PVIFA7%,20) + 1,000 (PVIF7%,20)

= 70(10.5940) + 1,000(0.2584)

= 741.58 + 258.40

= RM1,000 ♦ Sells at par value

Now assume that one year has passed and the bond is now a 9-year bond:

what would be the bond's value if the required rate of return were 8%, 14%,

and 20% respectively?

If k = 8% B0 = 70 (PVIFA4%,18) + 1,000 (PVIF4%,18)

= 70(12.6593) + 1,000(0.4936)

= RM1,379.75 ♦ Sells at a premium

If k = 14% B0 = 70 (PVIFA7%,18) + 1,000 (PVIF7%,18)

= 70(10.0591) + 1,000(0.2959)

= RM1,000 ♦ Sells at par value

If k = 20% B0 = 70 (PVIFA10%,18) + 1,000 (PVIF10%,18)

= 70(0.2014) + 1,000(0.799)

= RM754.00 ♦ Sells at a discount

The reason a bond's price rises and falls as interest rates change is due to

the fact that the Ringgit amounts of the coupons and maturity value are

constant regardless of the change in required rate of return. When a bond is

first issued, the corporation selling the bonds will usually adjust the coupon

rate to be equal to the prevailing required rate so that the new issue of bonds

will sell for par value.

In the above example, when the prevailing interest rate was 8% the bond sold

at a premium of RM380 over the par value. This occurred because the bond

is providing a 14% coupon rate while the required return is only 8%; thus,

many investors will rush to buy this bond and bid up the price of the bond in

the process. At a price of about RM1,380, the purchase earns exactly 8% if

the bond is held to maturity; and the price tends to stabilize. There are several

essential points to remember about bonds:


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1. Whenever the going rate of interest or yield to maturity (YTM) is equal

to the coupon rate, a bond will sell at its par value.

2. Whenever the YTM is above the coupon rate, a bond will sell below its

par value.

3. Whenever the YTM is below the coupon rate, a bond will sell above its

par value.

4. An increase in interest rates will cause the prices of outstanding bonds

to fall, while a decrease in rates will cause the prices of outstanding

bonds to rise.

5. The market value of a bond will approach its par value as its maturity

date approaches.

9.2 PREFERRED STOCK

It is a hybrid security (bond and common stock) that receives preferential treatment over

common stock holders. It is classified as equity but has characteristics of debt securities

embedded in its features. The use of preferred stock to finance capital projects are

somewhat more risky than common stock but less risky than bonds. As for the investors, the

reverse holds; that is preferred stock is less risky than common stock but more risky than

bonds.

Preferred stock is legally an equity security; that is, it represents ownership rather than a

loan, although it usually has characteristics similar to debt. These include:

1. Par value normally stated at RM100.00 per share.

2. Fixed annual dividend payments stated in percentage of the par value. This feature

is an exception for participating preferred. Dividends payment is calculated at

dividend rate time’s par value.

3. Participating dividend. Participating preferred stockholders receive dividends based

on prescribed formula as agreed upon during the issue. Normally it is pegged to the

earnings’ of the company.


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4. Claims on earnings and assets are senior to common stock, but after bonds.

5. Dividends are paid prior to common stock holders, normally at fixed rate and

cumulative depending on the issue. Any unpaid dividends for the prior period must be

paid before dividends are paid to common stock holders. Therefore, preferred

shareholders cannot be jeopardized in favor of common.

6. Maturity date. Normally preferred stock does not have maturity date similar to that of

common stock. The issue is perpetuity in nature and issuer usually retires it by

repurchase it in the open market. For preferred stock with conversion features, it can

be exchange for another securities, normally common stock at prescribed rate.

However, there are issues that have a fixed maturity date and even with a sinking

fund provision.

7. Callable features. Preferred with redeemable or callable features can purchased by

the firm within the prescribed time before the maturity date.

a) The Cost of Preferred Stock

There are two types of preferred stock; callable or non-callable basis. If it is

callable, the cost is calculated in the same manner as the cost of bonds,

before tax, with the call date is the maturity date. Our focus is on the non-

callable preferred stock.

To illustrate, let assume that, TMAfiq plans to issue RM1,000,000 of RM100

par preferred stock that pays 10 % dividend. The market price of the issues is

RM98 with 5 % of flotation cost. The net proceeds are:

Face value; normally at RM100 100

Less: Discount 100 – 98 2

Flotation cost 100(0.05) 5

Net proceeds (P0 – F) 93


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The after-tax cost of the preferred issues:

Note that the after-tax cost of preferred stock is higher, even the dividend rate

is lower than the coupon rate on debt in previous calculation. This is mainly

because preferred dividends are not tax deductible.

The market value for perpetuity preferred stock is easy to determine relative

to preferred with callable features. As earlier mentioned, it can be treated as

debt or bond determining its value.

To illustrate, let assume that the above preferred is callable after 5 years, at

par value of RM100. If the preferred stock has a yield of 12%, the value can

be determined as follows:

P0 = (100 x 10%)(PVIFA12%,5) + 100 (PVIF12%,5)

= 10 (3.6048) + 100 (0.5674)

= RM92.79

Therefore, the fair market value for the above preferred with call features is

RM92.79 with the expected yield of 12%.

Kps = Dps / (P0 – F)

Consequently, P0 = Dps / Kps

Where Kps : After-tax cost of preferred stock

Dps : The annual cash dividend on preferred; stated

percentage rate times the face value

P0 : The selling price of preferred

F : The flotation cost in Ringgit

Kps = (100 x 10%) / (98 – 5)

= 10.75%

P0 = Dps / Kps

= (100 x 10%) / 0.1075

= RM93.02


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9.3 COMMON EQUITY Common stock or equity represents an ownership of the firm, and the stockholders are the

owners collectively. Their ownership position will directly depend on the amount of common

shares held relative to the total number of common shares outstanding in the market.

Normally a 50% or more ownership is necessary in order to have management control of the

firm, whereby one share of common stock represents one voice or vote in the management.

In essence, common stockholders are the real owners of the firm and will bear more risk

than preferred owners and lenders. They have the residual claims on earnings and assets

after lenders and preferred respectively. Common stockholders stand to earn highest return

given the performance of the firm is good, but stands to loose everything is the firm goes

bankrupt. The following sections will present some of the essential characteristics of

common stock for understanding.

b) Balance Sheet Accounts and Definitions

1. Par Value: A stock's par value is an arbitrary value that indicates the

minimum amounts of money stockholders has put up, or that they

must put up in the event of bankruptcy. Actually, the firm could legally

sell new shares below par value, but any purchaser would be liable for

the difference between the issue price and the par value in case the

firm went bankrupt.

2. Retained Earnings: The total or cumulative amount to retained

earnings that have been reinvested in the firm since its inception to

date. It is considered as internal source of financing.

3. Paid-in Capital: This account shows the difference between the

stock's par value and what new stockholders paid when they bought

newly issued shares of common stock.

c) Legal Rights and Privileges of the Common Stockholders

1. Control of the Firm. The stockholders have the right to elect the

board of directors for the firm, which in turn, selects the officers who

will manage the firm. For a publicly held firm, the stockholders can


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remove the firm’s management if they decide as a group that the

management is not performing effectively. The state and local laws as

well as the corporate by-laws under which the firm is incorporated

specify this exercise of stockholder’s control for a given firm.

2. Proxy. A stockholder can transfer voting control of his shares to

another person or group of persons through this instrument.

Management always solicits shareholder proxies and usually gets

them. However, if earnings are poor and shareholders are dissatisfied,

an outside group may solicit the proxies in an effort to overthrow

management and take over control of the business. This is known as

a proxy fight.

3. Preemptive Right. This is a special right given to the existing

common shareholders of a firm. If entitle them to purchase any

additional shares sold by the firm. The purpose of the preemptive right

is two-fold that is:

a. to protect the power and control of the present shareholders;

and

b. to preserve current shareholders' value in the firm.

Due to the right to purchase any additional shares in proportion to

current ownership, it means that a shareholder can maintain the same

percentage ownership of a firm even if new shares are issued at

below market value. Though a new below-market price issue may

affect the per-share price of stock, the value of the total stock held by

a given shareholder will not be diluted if he exercises his right and

purchases additional shares (or sell the rights and invests those

proceed elsewhere).

4. Limited liability. Even the common shareholders are the rightful

owner of the company, their liabilities is only limited to the amount of

their original investments.


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d) The Market For Common Stock

Common stocks are bought by individual investors, institutional investors,

foreign investors, and by corporate investors. More recently, a tremendous

change in the way people saves has greatly increased the proportion of

stocks held by institutional investors and individuals alike.

Their management groups generally own the stocks of smaller companies;

such companies are called closely held corporation, or closed corporations. A

large number in investors not actively involved with management owns most

of the stock of larger firms; these companies are known as publicly held

corporation. The managers of most publicly held firms own some shares, but

not the 50% plus necessary for absolute voting control, although in some

instances the management of public companies does have voting control.

Stock market transactions can be classified into three distinct categories:

1. Trading in the outstanding shares of established, publicly owned

companies in the secondary market.

2. Additional shares sold by established, publicly owned companies in

the primary market.

3. New public offerings or Initial Public Offerings (IPO) by privately held

firms in the primary market.

There are two basic types of securities markets; the organized exchanges,

such as the Kuala Lumpur Stock Exchange, and the less formal over-the-

counter markets.

e) Common Stock Valuation

Common stocks provide and expected future cash flow stream, and stock

values are found in the same manner as the values of other financial assets;

that is the present value of a future stream of income. The expected cash

flows for common stocks consist of two elements:

1. The dividend expected in each year; and


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2. The price investors expect to receive when the sell the stock, that

includes a return of the original investment plus a capital gain (or

minus a capital loss).

In practice, we find that we can value common stock as the present value of

expected future dividends only, even for an investor who only plans to firm will

go bankrupt at some time in the future. Some key terms to understand are:

1. Stock. Is a security that gives the holder a limited liability ownership in

a firm, along with the right to share in the profits of the firm.

2. Par Value. Is the value of a share of stock carried on the firm's

balance sheet; this value usually has no relationship whatsoever to

the market value of the stock.

3. Dividends. It represents a distribution of income distributed

periodically as firm declares dividends on its common stock; paying

some amount per share to all shareholders.

4. Market Value. It is the price per share or value of the stock in the

market; that is what investors are willing to pay for a share of the firm's

stock.

5. Residual claims. Common stock holders are owners of the company,

and therefore the claims on earnings and assets are residual.

The value of the stock at any point in time is simply the present value of the

expected dividend stream. The following symbols will be used extensively

throughout in stock valuations;

Where Dt : Expected dividend at the end of year t in RM

Pt : Price of the stock at the end of year t in RM

g : The expected growth rate of the stock's price in percentage

t : year t, 0 is the current value

k : The required rate of return for the stock, and in percentage

D1 / P0 : Dividend yields

(P1 – P0) / P0 : Expected capital gains yield during the coming year.


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Thus, the value of a stock can be expressed as:

P0 = D1(1 + k)-1 + D2(1 + k) -2

+ ... + D∞(1 + k)-∞

This stock valuation model is the most general model available because it

makes no assumptions about future changes in dividends. Actually, these

dividends could be rising, falling, constant or completely random. In theory,

this is fine, but in practice, it makes the stock impossible to value; therefore,

we will examine other types of stock valuation models. These models are all

based on the above general model, with some specific assumptions about the

pattern of future dividends. For our purpose, the focus is on: (1) zero growth

model for evaluation of preferred stock; and (2) constant growth model for

evaluation of common stock.

Model #1: Zero Growth (Constant Dividend) Model

This model assumes that the dividends will remain constant year after

year. In practice, this model is most often used to value preferred

stock and perpetual bonds, both of which offer a constant annual

payment the owner.

∞ P0 = D(1 + k )

-1 + D(1+k )

-2 + ... + D(1 + k )-∞ = D Σ (1 + k )

-t

t=1

The infinite summation is equal to 1 / k. The price of the stock is therefore

equal to:

P0 = D / k

Therefore k = D / P0

Alternatively, k = D / (P0 – F) Where F is Floatation cost in RM


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Model #2: Constant or Normal Growth Model

This model assumes that a firm's dividends will grow at a

constant rate over time. This is the most common model in

common stock evaluation as it is applicable to many types of

corporation. Thus, at any point in time we can express the firm's

expected dividend as:

The above is known as the Gordon Growth Model. A necessary

condition the model to work is that g is less than k; or else the stock

value is negative that is not feasible.

The model can be rearranged to solve for the expected rate of return

given the next period's dividend, current stock price and expected

growth rate: That is:

Dt = D0 (1 + g)t

Moreover, the general stock valuation model can be written as:.

P0 = D1(1 + k )- 1 + D2(1+k )- 2 + ... + D∞(1 + k )-∞

If growth (g) is constant, then the previous equation simplifies to:

P0 = D1 / (k – g)

Kcs = Expected dividend yield + capital gains yield

= (D1 / P0) + g

Alternatively Kcs = [D1 / (P0 – F)] + g Where F is floatation cost RM


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Model #3: Non-constant dividends and non-constant growth

If a firm's growth rate is expected to be non-constant (or even random)

for a long period of time, it will be very difficult to arrive at a value for

that firm with the model's discussed so far. The general model would

of course be applicable, but we would have an extremely hard time

figuring out what the expected dividends were going to be. Details of

this model will be covered in advance finance course such as in

Investment Management the coming semester.

f) The cost of common equity.

A firm's cost of equity is the rate of return that investors expect to get from

their investment in the firm. It is also the rate of return a firm must earn from

its capital investments in order to keep its share price from declining. As such,

inability to get a high enough rate of return as expected by the investors

would result in the firm's share price to decline, and vice versa. Common

stockholders' returns consist of two components:

1. The cash flow from dividend payments; that the investors receive

during the period they hold the shares. Unlike interest on debt and

dividends on preferred, payment of cash dividend is not obligatory and

up to the discretion of the firm's board of directors to declare for

payments; how much and when.

2. The capital gain or loss realizes from holding the shares in a given time period. Capital gain or loss refers to the increase or

decreases in shares price relative to the original purchase price,

respectively. It can be realized when the shares are sold above or

below the original purchase price.

The holder wills discounts both of these expected cash flows to determine

rate of return expected from the investments. In reality, the determination of

the cost of equity, internal or external, is much more complicated than of debt

or preferred. This is because future dividends or returns are uncertain; its

amount, timings and availability as its payment are not obligatory.


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The cost of equity the firm incurs to finance its capital investment

consists of: (1) cost of retained earnings or internal equity; and (2) cost

of new common stock or external equity. It utilize the valuation approach method or the discounted cash flow method, that expresses

the current market price of common stock as the present value of

expected dividends, discounted at the holder's required rate of return.

Thus:

However, if the expected dividends are assume to grow at a constant rate

over the years, or the constant growth model as above mentioned, then the

above formula can be restate as follows:

P0 = D1 / (Kre – g)

Where g is the constant expected annual growth rate in cash dividends

To solve for the required rate of return, Kr:

Kre = (D1 / P0) + g

From the above formula, we can summarize that the required rate of return of

investors equals to dividend yield (D1 / P0) plus a capital growth (g)

percentage. Under the opportunity cost principle, the investors' required

rate of return is in essence the cost of retained earnings for the firm.

Retained earnings are the balances of earnings available to common

stockholders after the firm pays dividends to common stockholders. The firm

for reinvestment purposes retains that portion of net income.

Unlike internal equity, new equity issues require the firm to incur additional

costs of issuing the shares; or flotation costs. In order to account for these

extra costs, the proceeding represents the formula for cost of new equity or

cost of common stock:

P0 = D1 / (1 + Kre)1 + D2 / (1 + Kre) 2 + ... + Dn / (1 + Kre) n

Where P0 : The current market price of the stock

Dt : The expected dividend at the end of year t

Kre : The expected rate of return of investors


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Another method to calculate the expected rate of return required by the

investors or cost of retained earnings utilizes the information of cost of

common stock, investors personal tax rate and brokerage fees; as follows:

where Kcs = The cost of common stock

Tpr = Investor's personal tax rate

Fb = Brokerage fees

This above equation is based on the assumptions that: (1) all earnings are

distributed to common stockholders; and (2) they in turn will reinvest the

money in other securities of their choice. The calculation of the cost of

retained earnings in the following sections is based on the above formula.

To illustrate the calculations of the cost of common stock and the cost of

retained earnings, let assume that TMAfiq Inc., is planning to issue a new

common stock that incurs flotation cost of 5% and expects to pay dividend of

RM0.20 with 10% growth rate. The market price of the shares is RM5. The

company estimates that on the average, the investors' personal tax rate is

25% with brokerage fees of 10%.

Kcs = D1 / (P0 – F) + g Where F : The flotation cost in RM. Normally = flotation cost %(face value)

Kre = Kcs (1 – Tpr)(1 – Fb)

Cost of Common Stock Kcs = [D1 / (P0 – F)] + g

= 0.20 / 5.00 – (5.00(0.05)) + 0.10

= 14.21%

Cost of Retained Earnings Kre = Kcs (1 – Tpr)(1 – Fb)

= 14.21% (1 – 0.25) (1 – 0.10)

= 9.59%

Or by another approach Kre = (D1 / P0)+ g

= (0.20 / 5.00) + 0.10

= 14.00%


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The second approach to determine the cost of retained earnings considers

retained earnings as internally generated equity and therefore no floatation

costs involves in acquiring the funds. Therefore, the basic constant growth

formula can be used while ignoring the floatation costs (F) in event there is no

financial data on personal tax rate and brokerage fees.

The above example assumes that the growth rate for TMAfiq is at 10% and

the expected dividends at RM0.20. Estimating the growth rate and expected

dividend is important in the evaluation of the cost of common stock. Even

though there are several ways to determine the growth rates, the following

example will employ the valuation approach method to estimate the growth

rates from dividends paid by TMAfiq Inc., for the last five years and the

expected dividends for 1995, are as follows:

1994 RM0.1801 FV4

1993 0.1650

1992 0.1500

1991 0.1350

1990 0.1236 PV0

By using the valuation approach method and let 1990 as the current year, the

growth rate equals to:

PV0 = FV4 (PVIFk,4)

0.1236 = 0.1801 (PVIFk,4)

PVIFk,4 = 0.6863

Looking across the PVIF table through row 4; 0.6863 lies under 10%.

Therefore, the growth rate for TMAfiq dividends for the past four years is

10%. The estimated growth rates can, then be used to determine the

expected dividend for end of year one:

Expected dividend = Current dividend (1 + growth rate)

D1 = D0 (1 + g)

= 0.180 (1 + 0.10)

= 0.198


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The cost of new issues generally is higher than the cost of internal equity

because there are flotation costs involved in selling new common stock. Thus,

the cost will be slightly higher than the cost of retained earnings. The above

calculations for TM Afiq Inc., under the valuation approach substantiate this. It

shows that the after-tax cost of new equity is higher; 14.21% compared to

9.59% for retained earnings.

9.4 THE PROS AND CONS OF LONG-TERM FINANCING The use of long-term financing provides its own advantages and disadvantages.

a) Cash Costs for Issuer and Returns to Investors Are Limited

Regardless as how profitable the company is or may become bondholders and

preferred shareholders receive only a fixed, limited income. This is an advantage

from the firm's standpoint, as much of the operating income is available for the

common stockholders, but it is a distinct disadvantage to the bondholders and

preferred stockholders.

b) Bondholders and Preferred Holders Have No Management Control

Typically, bondholders and preferred stockholders are not entitled to vote for

directors; that is, voting control of the firm lies in the hands of the common

shareholders. Thus, when a firm is considering alternative means of financing, if the

existing management group is concerned about losing voting control of the business,

then selling bonds or preferred stock will have and advantage over financing with

common stock.

c) Costs of Bond Are Cheaper

Bond-interest is a deductible expense to the issuing firm, so for a firm in the 38% tax

bracket, the federal government in effect pays 38% of the interest charges on debt.

Thus, bonds have and advantage over common and preferred stock to a corporation

planning to raise new capital.


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d) Risk To the corporation, bonds or term loans, especially those with sinking funds of

amortization payments, entail significantly more risk than do preferred or common

stock. Further, the shorter the maturity, the greater the risk. From the investor's

viewpoint, however, bonds (or term loans) are safer because of a promised to

receive fixed stream of cash flows.

e) Inflexibility of Long-Term Debt

The indenture provisions on a long-term bond are generally much more stringent

than they are either in a short-term credit agreement or for common preferred stock.

Hence, the firm may be subject to much more disturbing and crippling restrictions

under a long-term debt arrangement that may limit the firm's future financing

decisions.

Similarly, there is a limit on the extent to which funds can be raised through long-term

debt. This is because there is a generally accepted standard of financial policy;

dictate that the debt ratio must not exceed certain limits. When debt grows beyond

these limits, its cost rises rapidly, or it may simply cease to be available.

9.4.1 Cost of Capital

Cost of Capital is the minimum rate of return that the firm must earn on its

capital investment project in order to satisfy the required rate of return of the

firm’s investors. Therefore it is considered as the cost of long-term funds as

discussed in the above section.

The firm needs to look at its cost of capital before venturing into any project.

This cost is correlated with the share price of the firm. If the rate of return on

the investment is higher than the cost of capital, the share price will increase

and vice versa. Let’s look at the following discussion to determine the

individual cost of capital and later the Weighted Average Cost of Capital

(WACC).


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1. Cost of debt (bond)

Cost of debt is defined as the rate that must be received from an

investment to achieve the required rate of return for the creditors.

a) The calculation on the cost of bond if it is sold at par value.

Kd = Annual interest Par value Kd (after tax) = kd (1 – tax rate)

Example:

Malcom bonds were issued last week with 12 years maturity

and coupon rate of 10%. It is currently selling at RM1,000. If

the tax rate is 35%, what is the cost of the fund?

First calculate the amount of interest which is

= 0.1 x 100 x 1

= RM 100

Therefore Kd = Annual interest par value = 100 1000 = 10%

Kd = debt + holder’s required return rate of return n

Since Po = ∑ It + M (1 + Kd) t (1 + Kd)n t=1

= If + (PVIFAkd.n) + M(PVIFkd,n)

Where Po = Market Value of debt

I = Interest

$M = Face value

N = Years of bond


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Kd (after tax) = 0.1 (1 – 0.35)

= 0.1 x 0.65

= 6.5%

b) The calculation on cost of debt if it is sold below or above par

value

Kd = i + (PV – mp) ____n_______

PV + mp 2

And Kd (after tax) = Kd (1 – tax rate)

Where i = amount of interest

PV = par value

mp = market price

n = maturity period

Example:

Tenong Bhd is considering to issue bond with 11% coupon

rate. Market price is RM900 and maturity period is 20 years.

The marginal tax rate of the firm is 40%. Calculate the cost of

issuing the bond.

Kd = 0.11 x 100 + (100 – 900) 20 = 1000 + 900

2

950

= 115 950 = 12.111%

Kd (after tax) = 0.1211 (1-0.4)

= 7.27%


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Floatation cost – is the cost associated with the issuing of long-

term funds.

For example, broker’s fees, commission fees, legal fees and

underwriting fees.

Kd = Amount of interest Par value-floation cost Kd = i + [PV – (mp-FC)] n [PV + (mp –fc) ] 2 Where FC is flotation cost

2. Cost Of Preferred Stock

Kps = Annual dividend in dollars

Current market price/par value

Kps = Annual dividend Mp-FC (if there is a flotation cost)

Example:

A Company issued preferred stock with dividend rate of 8.5% of par.

The cost of issuing this is estimated at 4% of selling price. What is the

cost of it?

Kps = D MP-FC

= 8.5 = 8.85% 100-4

Where:

D = Dividend

MP = Market Price

FC = Flotation Cost


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3. Cost Of Common Stock

Therefore: D1 = 2.20 (1+0.05)

= 2.31

So, Ke = 2.31 + 0.05 50

= 9.62%

9.4.2 Weighted Average Cost of Capital (WACC)

A firm’s weighted cost of capital is a composition of the individual costs of

financing, weighted by the percentage of financing provided by each sources.

Therefore, the firm’s weighted costs of capital is a function of :

i) the individual costs of capital

ii) the makeup of the capital structure – the percentage of funds provided

by debt, preferred stock and common stock

So the formula to calculate the overall cost of capital is

Example:

Megah Manufacturing plans to increase fixed assets by RM 5 million by the

end of the year. The present capital structure is considered optimum and is

as follows:

6% bond, RM 35 million

7% preferred stock, RM 25 million

Common stock, RM 40 million

Ke = D1 + g and D1 = Do (1 + g) Mp

Ko = ∑ (% of total capital structure supplied by each type of capital)

X (cost of capital for each source of capital)


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New securities can be issued as follows:

a) 20 years, 7% bond, interest to be paid annually for RM 930 less

Flotation cost of 4%

b) 80% preferred stock to be sold at par

c) Common stock for RM 90 less Flotation cost of 8%.

The corporate tax rate is 45%. The company paid dividend of RM 6 last year

and the expected growth is 7%. What is the weighted average cost of capital

of financing the investment?

Answer:

1. We have to calculate the cost of each capital

a) Kd = 70 + (1000 – (930-40) 20 1000 + (930-40) 2 = 7.98%

Kd (after – tax) = 0.798(1-0.45)

= 4.39%

b) Kd (after-tax) = 8

100%

c) Ke = D1 + g mp-FC Where D1 = Do (t t + g)

= 6(1+0.07)

= 6.42

FC = 8% (90)

= 7.2

Ke = 6.42 + 0.07 90-7.2 = 14,75%


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2. Calculate the weight of each capital

i) Bond = 35 m = 0.35 100m

ii) Preferred Stock = 25 m = 0.25 100m

iii) Common Stock = 40 m = 0.4 100m

3. Ko = (0.35)(4.39%) +(0.25)(8%) +(0.4) (14.75)

= 9.44%


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QUESTION 1

a) KUAT Public Utilities issued a bond that pays RM80 annual interest with

RM1,000 par value. It matures in 20 years. The required rate of return is 7

percent.

i) Calculate the value of the bond.

ii) How does the value change if the required rate of return increases to

10 percent?

iii) Assume that the bond matures in 10 years instead of 20 years.

Recomputed your answers in (ii).

b) You are considering two (2) financing proposals. The first proposal that you

are analyzing is a preferred stock (RM100 par value) that sells for RM90 and

pays annual dividend of RM13. The second proposal is a common stock that

recently paid a RM2 dividend and the stock is selling for RM20. The rate of

growth in earnings for this common stock is 10 percent.

i) Calculate the cost of issuing common stock.

ii) Calculate the cost of issuing preferred stock.

iii) Which financing proposal to be accepted and why?

c) Explain briefly the terms ‘stock dividend’ and ‘stock split’.

(20 marks)


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QUESTION 2

a) Dynamic Corporation needs RM3.2 million for its long term expansion

projects. As the Financial Manager of the company, you are required to

evaluate the costs of the following financing alternatives :

i) Issue common stock. The price of the existing shares of the company

is RM35. The expected dividend for next year is RM3.30 and the

growth rate will remain at 4 percent. The flotation cost is 5 percent fo

the issue price.

ii) Issue 8 percent coupon interest bond of 10 years. The market price of

a similar bond is RM950. The flotation cost is 4 percent of the par

value of RM1000. The current tax bracket of the firm is 10 percent.

iii) Issue a 12 percent preferred stock with a par value of RM100. The

flotation cost is 2.5 percent of the par value and the market price is

RM135.

Calculate the cost of each alternative and choose the best alternative.

(4+7+4+1=16 marks)

b) Give any four (4) characteristic of common shares.

(4 marks)

(Total : 20 marks)


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QUESTION 3

a) Sinaran Sdn Bhd paid a dividend of RM2.00 last year and its stock is currently

selling at RM45 a share. The company is expected to grow 8 percent per

annum indefinitely. What would be its cost of equity from new stocks if

floatation cost were 10 percent of the money raised?

(4 marks)

b) i) Astana Bina Sdn Bhd issued preferred shares at a face value of RM80

to yield 11 percent ten years ago. The shares are currently selling at

RM 100. Assuming the company’s tax rate is 30 percent. Calculate the

cost of these shares?

(4 marks)

ii) Calculate the after tax cost of preferred stock?

(2 marks)

c) Cahaya Sdn Bhd has decided to borrow RM5 million of external funds

through issuing bonds that pay 8% interest and will mature in 15 years. The

firm is planning to sell the bonds at 5% discount. Current tax rate is 30%.

What is Cahaya’s after – tax cost of debt?

(5 marks)

d) Preferred stocks are said to be hybrids of common stocks and bonds. Explain

fully.

(5 marks)


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FINANCE MANAGEMENT FIN420 chp 9

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