CHAPTER 18: Long-Term Financing Decisions

PROBLEM 1
The weighted average cost of capital is computed as follows:
Cost of Capital Weight Weighted Cost of
Capital
Debt 7% 35% 2.45%
Preference Shares 10% 15% 1.5%
Ordinary Equity 13% 50% 6.5%

WACC 10.45%

PROBLEM 2
To compute for the weighted average cost of capital, the cost of debt, cost of preference
shares, and cost of ordinary equity must be determined first.
a. Cost of Debt
Kd = IR ( 1 – TR)
Kd = 10% ( 1 – 34% )
= 10% ( 0.66 )
Kd = 6.6%
where:
Kd = cost of debt
IR = bond yield or interest rate on bonds
TR = corporate tax rate

b. Cost of Ordinary Shares

D
KOS = +g
P

P3.50
= + 6%
P70.00

KOS = 11%
Where:
KOS = Cost of Ordinary Shares
D = Expected Dividends per Share
P = Market Price per Share
g = Growth Rate
c. Cost of Preference Shares
D
KPS = P (1−F)

P9.00
= P102.00 (1−3.14%)

P9.00
= 98.80

KPS = 9.11%
where:
KPS = Cost of Preference Shares
D = Expected Dividends per Share
P = Market Price per Share
F = Percentage of flotation cost relative to the price of share

P3.20
F = P102.00

= 3.14%
 Flotation costs are the costs paid by the company when raising capital through the
issuance of new stocks. In the equation, it is expressed as a percentage of the share price
because these costs will be deducted from the proceeds that will be received by the
company from the issuance. Essentially, only a certain percentage of the share price will
be received after deducting the flotation costs.

The weighted average cost of capital is computed as follows:

Cost of Capital Weight Weighted Cost of

Capital
Debt 6.6% 30% 1.98%
Ordinary Equity 11% 60% 6.6%
Preference Shares 9.11% 10% 0.91%

WACC 9.49%
Cost of Capital Weight Weighted Cost of
Capital
Debt 6.6% 30% 1.98%
Ordinary Equity 11% 60% 6.6%
Preference Shares 9.11% 10% 0.91%

WACC 9.49%
CHAPTER 19: Sources of Intermediate and Long-Term Financing: Debt and Equity
PROBLEM 1
Required:
A. The Vice President of Finance asks you to calculate earnings per share and the market
value of the stock (assuming the price earnings ratios given are valid estimates) for the
two proposals assuming total sales (including the new product line) of:
1. 400,000
2. 600,000
3. 800,000

ANSWER:
 Under the first proposal (debt financing), Cam Furniture Company is required to
issue long term debt amounting to P100,000 (this amount is 50% of present level
assets, and the additional capital needed for plant and inventory expansion.
 Under the second proposal (equity financing), Cam Furniture Company is
required to issue shares the will yield a total amount of P100,000. Since the
investment banker believes that company will yield P 33 1/3 for every share that
will be issued, the company shall issue 3,000 shares (P100,000/ P33 1/3 per share)

Assuming total sales of P400,000

Debt Financing Equity Financing
Sales 400,000 400,000
Operating Costs (360,000) (360,000)
Operating Income 40,000 40,000
Interest Charges (7,000) (2,000)
Net income before taxes 33,000 38,000
Less: Taxes (50%) (16,500) (19,000)
Net Income 16,500 19,000

Earnings per Share

Debt Financing cannot be determined
Equity Financing
(19,000/ 13,000 shs) P1.46
Market Value of the stock
Debt Financing cannot be determined
Equity Financing
(P1.46 * 12 times) P17.52
 Assuming total sales of 600,000
Debt Financing Equity Financing
Sales 600,000 600,000
Operating Costs (540,000) (540,000)
Operating Income 60,000 60,000
Interest Charges (7,000) (2,000)
Net income before taxes 53,000 58,000
Less: Taxes (50%) (26,500) (29,000)
Net Income 26,500 29,000

Earnings per Share

Debt Financing cannot be determined
Equity Financing
(29,000/ 13,000 shs) P2.23
Market Value of the stock
Debt Financing cannot be determined
Equity Financing
(P2.23* 12 times) P26.76

Assuming total sales of P800,000

Debt Financing Equity Financing

Sales 800,000 800,000
Operating Costs (720,000) (720,000)
Operating Income 80,000 80,000
Interest Charges (7,000) (2,000)
Net income before taxes 73,000 78,000
Less: Taxes (50%) (36,500) (39,000)
Net Income 36,500 39,000

Earnings per Share

Debt Financing cannot be determined
Equity Financing
(39,000/ 13,000 shs) P3.00
Market Value of the stock
Debt Financing cannot be determined
Equity Financing
(P3.00 * 12 times) P36.00
 Notes/ Explanations:
 The total interest charges under debt financing is 7,000
o (40,000 * 5%) + (100,000 * 5%) = P7,000
 The total number of shares outstanding under equity financing is 13,000
shares (10,000 shares + additional 3,000 shares)
 The students believe that the there is a missing information with regards
to the P/E ratio of proposal for debt financing. The PE ratio of 12 to 1
cannot be used for debt financing because the problem provides that PE
ratio would remain at 12 to 1 if only the additional stocks were issued.
Computation for the number shares outstanding before issuance of
additional shares (in view of choosing the proposal of equity financing)
P/E Ratio = share price/ earnings per share
EPS = share price/ PE Ratio
= P36/ 12 times
= P3.00
No. of = Net Income/ EPS
Shares outstanding
= P30,000 / P3.00
= 10,000 shares

 The formula for earnings per share is:

𝐸𝑃𝑆 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 /Number of Ordinary Shares Outstanding

 The formula for market value of the stock is

𝑀𝑉 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 = 𝐸𝑃𝑆 ∗ 𝑃𝐸 𝑅𝑎𝑡𝑖𝑜

 B. Which proposal would you recommend? Your answer should indicate:
1. The criteria used to judge the alternatives.
Proposal 1: Issuance of Proposal 2: Issuance of
Criteria
debt shares
None (less vulnerable to
decline in sales and
Possible liquidity problems Present
earnings; company is not
obligated to pay dividends)
Present (there are fixed
interest payments
Increased bankruptcy risk None
regardless of company’s
economic position)
May depress the market
Credit rating is enhanced
value of company’s
Effect of proposal on the or maintained; higher
outstanding ordinary shares
image of the company credit rating enhances
if used beyond a given
stock value
point

2. A brief defense of the criteria used.

Cam Furniture Company is considering a plant and inventory expansion amounting to
100,000 (equal to 50% of its present asset level which is significant) to handle the anticipated
volume of a new product line. Since the company’s product is new to the market, the sales
growth during its early years is not guaranteed to be steady and high enough to be able to pay the
fixed interest and principal payments when a large debt is to be issued. Hence, the criteria of
liquidity problems and bankruptcy risk is created. In addition, Cam Furniture Company is
currently expanding its business so it is necessary to maintain a good credit standing to enhance
the value of its stock, hence, the last criteria is created.
3. The proposal chosen in accordance with the criteria.
The Proposal 2 or the issuance of shares is chosen because the bankruptcy risk and
possible liquidity problems of the company which is currently undergoing through an expansion
is minimized. Moreover, the company is not obligated to pay fixed payments but rather pay
dividends whenever the sales of the company is already stable. Lastly, the credit rating of the
company is maintained by issuing equity, thus making it easier for the company to obtain loans
in the future for further expansion (when expansion guarantee high and steady revenue).
 C. Would your answer to B change if sales level of 1,200,000 or more could be achieved?
Explain.
No. The higher level of sales won’t affect the criteria mentioned above. Even if the sales
level increased, possible liquidity problems and bankruptcy risk will still be present if the
company chose to issue debt.

D. What reason(s) would the investment broker give to support the estimate of a lower price-
earnings ratio if debt is issued?
The first step in computing the price-earnings (P/E) ratio is to calculate the earnings per
share (EPS). Typically, EPS is the company’s after tax profits divided by the number of shares
outstanding. From the EPS, we can calculate the P/E ratio by dividing the company’s current
market share price by the earnings per share.
If debt is issued, the company’s EPS would be higher compared to the EPS if shares are
issued because of the corresponding increase in shares outstanding which will be used as the
denominator. Therefore, the company will get a lower P/E ratio because of the higher EPS used.

Chapter 19: Problem 19-2

1. Long-term bonds

Earnings per Share = Net income after interest and taxes - preference dividends
Average number of ordinary shares outstanding

= P6,105,000 – 0
(26,330,000 + 26,330,000) / 2

= P6,105,000
P26,330,000 shs.

= P 0.23

Return on Ordinary Equity = Net income after interest and taxes - preference dividends
Average Ordinary Equity

= P6,105,000 – 0
(P 55,028,000 + P 55,028,000) / 2

= P6,105,000
P55,028,000

= 11.09%
Computations

Existing long-term debt (P13,395,000 x 9.5%) P 1,273,000

Long-term bonds (P15,300,000 x 10%) 1,530,000
Interest expense P 2,803,000

Net income before interest and taxes P12,978,000

Less: Interest expense 2,803,000*
Net income before taxes P10,175,000
Less: Taxes (40%) 4,070,000
Net income after taxes P 6,105,000

November 30,2014 No. of ordinary shares issued and outstanding 26,330,000 shares
November 30,2015 No. of ordinary shares issued and outstanding 26,330,000 shares

Total Equity – Preference Equity = Ordinary Equity

November 30, 2014 P55,028,000 – P0 = P 55,028,000
November 30, 2015 P55,028,000 – P0 = 55,028,000
Total = P110,056,000
/2
Ave. Ordinary equity for November 30,2015 P 55,028,000

Explanation
 No Preference dividend has been distributed for the year.
 No change of ordinary shares has been made for the year.
 The earnings per share if the entity choose to expand by issuing long bonds is equal to
the net income after interest and taxes of P6,105,000 divided by the average number of
ordinary shares outstanding of 26,330,000 shares.
 The return on equity is equal net income after interest and taxes of P6,105,000 divided
by average ordinary equity of P 55,028,000.

2. Preference Shares

Earnings per Share = Net income after interest and taxes - preference dividends
Average number of ordinary shares outstanding

= P7,023,000 – P1,657,500
(26,330,000 + 26,330,000) / 2
 = P5,365,500
P26,330,000 shs.

= P 0.20

Return on Ordinary Equity = Net income after interest and taxes - preference dividends
Average Ordinary Equity

= P7,023,000 – P1,657,500
P55,474,250

= P5,365,500
P55,474,250

= 9.67%

Net income before interest and taxes P12,978,000

Less: Interest expense 1,273,000
Net income before taxes P11,705,000
Less: Taxes (40%) 4,682,000
Net income after taxes before preference dividends P 7,023,000
Less: Dividends to preference (P12,750,000 x 13%) 1,657,500
Net Income available to Ordinary shares P5,365,500

Cash received from selling preference share P15,300,000

Divide by: Market Value per share P120
Number of Preference shares 127,500 shs.
Multiply by: Par value per share P100
Par value of Preference shareholder’s equity P12,750,000
Dividends to preference (P12,750,000 x 13%) P 1,657,500
Total Preference shareholder’s equity P14,407,500

November 30,2014 No. of ordinary shares issued and outstanding 26,330,000 shares
November 30,2015 No. of ordinary shares issued and outstanding 26,330,000 shares

Total Equity – Preference Equity = Ordinary Equity

November 30, 2014 P55,028,000 – P0 = P55,028,000
November 30, 2015 P70,328,000 – P14,407,500 = 55,920,500
(P55,028,000 + 15,300,000)
 Total = P110,948,500
/2
Ave. Ordinary equity for November 30,2015 P 55,474,250
Explanation
 No change of ordinary shares has been made for the year.
 The earnings per share when the entity choose to expand by issuing preference shares
is equal to the net income after interest and taxes of P7,023,000 less preference
dividends P1,657,500 divided by the average number of ordinary shares outstanding of
26,330,000.
 The return on equity is equal net income after interest and taxes of 7,023,000 less
preference dividends P1,657,500 divided by average ordinary equity of P55,474,250.

3. Ordinary shares

Earnings per Share = Net income after interest and taxes - preference dividends
Average number of ordinary shares outstanding

= P7,023,000 – 0
(26,330,000 + 33,980,000) / 2

= P7,023,000
P30,155,000 shs.

= P 0.23

Return on Ordinary Equity = Net income after interest and taxes - preference dividends
Average Ordinary Equity

= P7,023,000 – 0
P62,678,000

= P7,023,000
P62,678,000

= 11.20%

Net income before interest and taxes P12,978,000

Less: Interest expense 1,273,000
Net income before taxes P11,705,000
Less: Taxes (40%) 4,682,000
Net income after taxes before P 7,023,000
November 30, 2014 No. of ordinary shares issued and outstanding 26,330,000 shares
November 30, 2015 No. of ordinary shares issued and outstanding
New issued shares P15,300,000
Divide by: Market value per share P2
Number of Ordinary shares issued 7,650,000 shs.
Nov. 30, 2014 outstanding shares 26,330,000 shs. 33,980,000
shares
Total Equity – Preference Equity = Ordinary Equity
November 30, 2014 P55,028,000 – P0 = P55,028,000
November 30, 2015 P70,328,000 – P0 = 70,328,000
(P55,028,000 + 15,300,000)
Total = P125,356,000
/2
Ave. Ordinary equity for November 30,2015 P 62,678,000

Explanation
 No Preference dividend has been distributed for the year.
 The earnings per share when the entity choose to expand by issuing ordinary share the
net income after interest and taxes of P7,023,000 divided by the average number of
ordinary shares outstanding of 33,980,000 shares.
 The return on equity is equal net income after interest and taxes of P7,023,000 divided
by average ordinary equity of P62,678,000.

Members:
Graida, Carmela Grace
Ladines, Clarice Joy
Morado, Nicole Marian
Perlas, Bryan Justine
Polintan, Christine Jane
Victoria, Cris John