Short Term Capital funding

vs.
Long Term Capital Funding
 SC #3
Cash $12.00 $43.06
A/R $37.50 $50.37 Actual growth (g) = 79.09%
Inv. $55.00 $81.61
PP&E Net $120.00 $127.12 Sustainable growth rate (g*) = 31.86% (using t=1)
OLTA $6.25 $6.25
TA $230.75 $308.40
g > g*, and will run out of funds, Ceteris Paribus
A/P $2.50 $4.48
STB $6.25 $11.19
LTD $100.00 $131.86
OLTL $0.00 $0.00
Total Liabs. $108.75 $147.53
OCI $50.00 $50.00
C/S + APIC $29.00 $29.00
R/E $43.00 $81.87
Total Equity $122.00 $160.87
Total L+E $230.75 $308.40
Check Assets - Liabilities - Equities = 0 $0.00 $0.00

Sales $250.00 $447.73

COGS $147.00 $267.14
Gross Profit $103.00 $180.59
Depreciation Expense $9.00 $10.79
Other Expenses $55.00 $99.95
EBIT $39.00 $69.85
Interest Expense $3.50 $5.06
Taxes (at 40%) $14.20 $25.91
Net Income $21.30 $38.87

Net Income (or earnings) $38.87

+ Depreciation $10.79
- Increases in Working Cap -$32.56
+/- other non-cash adjustments $0.00
Total Operating CF's $17.10

- PP&E Purchases -$17.91

+ PP&E Sales $0.00
+/- other investments $0.00
Total Investments CF's -$17.91

+ Equity Issues (or - Equity repurchases) $0.00

+ Debt Issues (or - Debt Pmts.) $31.86
- Dividends $0.00
Total Financing CF's $31.86
Delta Cash $31.06
 SC #3
Cash $12.00 $43.06
A/R $37.50 $50.37 Actual growth (g) = 79.09%
Inv. $55.00 $81.61
PP&E Net $120.00 $127.12 Sustainable growth rate (g*) = 31.86% (using t=1)
OLTA $6.25 $6.25
TA $230.75 $308.40
g > g*, and will run out of funds, Ceteris Paribus
A/P $2.50 $4.48
STB $6.25 $11.19
LTD $100.00 $131.86 Is g<g*? FALSE
OLTL $0.00 $0.00
COGS+SG&A+Dep $377.88
Total Liabs. $108.75 $147.53
OCI $50.00 $50.00 Inc WK $32.56
C/S + APIC $29.00 $29.00 CAPex $17.91
R/E $43.00 $81.87
Capital required for the period $428.34
Total Equity $122.00 $160.87
Total L+E $230.75 $308.40 Bus. Capital = Eb+Db $222 $292.73
Check Assets - Liabilities - Equities = 0 $0.00 $0.00 Surplus/(Deficit) -$135.61
Sales $250.00 $447.73
COGS $147.00 $267.14
Gross Profit $103.00 $180.59
Depreciation Expense $9.00 $10.79
Other Expenses $55.00 $99.95
EBIT $39.00 $69.85
Interest Expense $3.50 $5.06
Taxes (at 40%) $14.20 $25.91
Net Income $21.30 $38.87

Net Income (or earnings) $38.87

+ Depreciation $10.79
- Increases in Working Cap -$32.56
+/- other non-cash adjustments $0.00
Total Operating CF's $17.10

- PP&E Purchases -$17.91

+ PP&E Sales $0.00
+/- other investments $0.00
Total Investments CF's -$17.91

+ Equity Issues (or - Equity repurchases) $0.00

+ Debt Issues (or - Debt Pmts.) $31.86
- Dividends $0.00
Total Financing CF's $31.86
Delta Cash $31.06
 SC #3
Cash $12.00 $43.06
A/R $37.50 $50.37 Actual growth (g) = 79.09%
Inv. $55.00 $81.61
PP&E Net $120.00 $127.12 Sustainable growth rate (g*) = 31.86% (using t=1)
OLTA $6.25 $6.25
TA $230.75 $308.40
g > g*, and will run out of funds, Ceteris Paribus
A/P $2.50 $4.48
STB $6.25 $11.19
LTD $100.00 $131.86 Is g<g*? FALSE
OLTL $0.00 $0.00
COGS+SG&A+Dep $377.88
Total Liabs. $108.75 $147.53
OCI $50.00 $50.00 Inc WK $32.56
C/S + APIC $29.00 $29.00 CAPex $17.91
R/E $43.00 $81.87
Capital required for the period $428.34
Total Equity $122.00 $160.87
Total L+E $230.75 $308.40 Bus. Capital = Eb+Db $222 $292.73
Check Assets - Liabilities - Equities = 0 $0.00 $0.00 Surplus/(Deficit) -$135.61
Sales $250.00 $447.73
COGS $147.00 $267.14
Gross Profit $103.00 $180.59
Depreciation Expense $9.00 $10.79
Other Expenses $55.00 $99.95
EBIT $39.00 $69.85
Interest Expense $3.50 $5.06
Taxes (at 40%) $14.20 $25.91
Net Income $21.30 $38.87

Net Income (or earnings) $38.87

+ Depreciation $10.79
- Increases in Working Cap -$32.56
+/- other non-cash adjustments $0.00
Total Operating CF's $17.10

- PP&E Purchases -$17.91

+ PP&E Sales $0.00
+/- other investments $0.00 THIS SCENARIO CAN NOT EVEN EXIST!!!!!!
Total Investments CF's -$17.91
HOW CAN YOU SPEND THE $ YOU DON’T HAVE YET,
+ Equity Issues (or - Equity repurchases)
+ Debt Issues (or - Debt Pmts.)
$0.00
$31.86
W/O BORROWING MORE OR EARNING IT FIRST?
- Dividends $0.00
Total Financing CF's $31.86 Note: Your Fin. Stmt projections still balance out!!!!
Delta Cash $31.06
 SC #4
Cash $12.00 $178.67
A/R $37.50 $50.37 Actual growth (g) = 79.09%
Inv. $55.00 $81.61
PP&E Net $120.00 $127.12 Sustainable growth rate (g*) = 15.09% (using t=1)
OLTA $6.25 $6.25
TA $230.75 $444.01
g > g*, but new equity $135.61, Ceteris Paribus
A/P $2.50 $4.48
STB $6.25 $11.19
LTD $100.00 $131.86 Is g<g*? FALSE
OLTL $0.00 $0.00
COGS+SG&A+Dep $377.88
Total Liabs. $108.75 $147.53
OCI $50.00 $50.00 Inc WK $32.56
C/S + APIC $29.00 $164.61 CAPex $17.91
R/E $43.00 $81.87
Capital required for the period $428.34
Total Equity $122.00 $296.48
Total L+E $230.75 $444.01 Bus. Capital = Eb+Db $222 $428.34
Check Assets - Liabilities - Equities = 0 $0.00 $0.00 Surplus/(Deficit) $0.00
Sales $250.00 $447.73
COGS $147.00 $267.14
Gross Profit $103.00 $180.59
Depreciation Expense $9.00 $10.79
Other Expenses $55.00 $99.95
EBIT $39.00 $69.85
Interest Expense $3.50 $5.06
Taxes (at 40%) $14.20 $25.91
Net Income $21.30 $38.87

Net Income (or earnings) $38.87

+ Depreciation $10.79
- Increases in Working Cap -$32.56
+/- other non-cash adjustments $0.00
Total Operating CF's $17.10

- PP&E Purchases -$17.91

+ PP&E Sales $0.00
+/- other investments $0.00
Total Investments CF's -$17.91

+ Equity Issues (or - Equity repurchases) $135.61

+ Debt Issues (or - Debt Pmts.) $31.86
- Dividends $0.00
Total Financing CF's $167.48
Delta Cash $166.67
 SC #4
Cash $12.00 $178.67
A/R $37.50 $50.37 Actual growth (g) = 79.09%
Inv. $55.00 $81.61
PP&E Net $120.00 $127.12 Sustainable growth rate (g*) = 15.09% (using t=1)
OLTA $6.25 $6.25
TA $230.75 $444.01
g > g*, but new equity $135.61, Ceteris Paribus
A/P $2.50 $4.48
STB $6.25 $11.19
LTD $100.00 $131.86 Is g<g*? FALSE
OLTL $0.00 $0.00
COGS+SG&A+Dep $377.88
Total Liabs. $108.75 $147.53
OCI $50.00 $50.00 Inc WK $32.56
C/S + APIC $29.00 $164.61 CAPex $17.91
R/E $43.00 $81.87
Capital required for the period $428.34
Total Equity $122.00 $296.48
Total L+E $230.75 $444.01 Bus. Capital = Eb+Db $222 $428.34
Check Assets - Liabilities - Equities = 0 $0.00 $0.00 Surplus/(Deficit) $0.00
Sales $250.00 $447.73
COGS $147.00 $267.14
Gross Profit $103.00 $180.59
Depreciation Expense $9.00 $10.79
Other Expenses $55.00 $99.95
EBIT $39.00 $69.85
Interest Expense $3.50 $5.06
Taxes (at 40%) $14.20 $25.91
Net Income $21.30 $38.87

Net Income (or earnings) $38.87

+ Depreciation $10.79
- Increases in Working Cap -$32.56
+/- other non-cash adjustments $0.00
Total Operating CF's $17.10

- PP&E Purchases -$17.91

+ PP&E Sales $0.00 THIS SCENARIO CAN EXIST DUE TO EXTRA EQUITY
+/- other investments $0.00
Total Investments CF's -$17.91 THAT HELPS IT COVER ITS DEFICIT. HIGH GROWTH
+ Equity Issues (or - Equity repurchases) $135.61
COMPANIES (IPO’s) NEED CAPITAL MARKETS DUE TO
+ Debt Issues (or - Debt Pmts.)
- Dividends
$31.86
$0.00
CAPITAL DEFICITS DURING STELLARLY HIGH GROWTH
Total Financing CF's
Delta Cash
$167.48
$166.67
EARLY STAGES (where g >>> g*)
PLEASE NOTE:
Even though you issued equity, your g is still greater than g*. Some students asked me,
“But, why didn’t g* improve, so that g ≤ g*?”

The answer to the aforementioned is as follows:

“You never improved the g*. That is why you issued the additional capital and that is why
the g* is still less than g (g > g*). The only reason why you can execute this plan is because
you plugged the deficit with the incremental capital”
In this prior example, the deficit of $135.61 was financed entirely by issuing new equity
Having issued the $135.61 entirely as incremental equity changes the financial leverage of the
next period versus the current period
FL0 = (100+122)/122 = 1.82 FL1 = (131.86+296.48)/296.48 = 1.44
What was Dm%? What will now Dm% be? $428.34
-1
Remember that FL0 = (Eb+Db)/Eb, which can also be viewed as Eb0% = FL0
Eb0% = 1/1.82 = 0.55 Eb1% = 1/1.44 = 0.69
Assume that the Price-to-Book multiple is 3x (P/B = 3x). Then,
Em = 3xEb0 = 3x0.55, Db0 = 0.45 Em = 3xEb0’ = 3x0.69, Db0’ = 0.31
Dm% = 0.45/(0.45+3x0.55) = 21% Dm% = 0.31/(0.31+3x0.69) = 13%
Companies “set” a Dm% as part of their financial policy. If it was 21%, how much should we
have issued from the $135.61 in Incremental Equity and how much in Incremental Debt?
Note: We are ignoring the effect of higher interest expense due to higher level of debt. That’s ok, as we are working on these examples by hand and not by using Excel

Turns out that to hold Dm% at 21%, FL1 = FL0, so…. We solve for FL1 = 1.82 = $428.34/Eb1
Eb1 = $428.34/1.82 = $235.35 = (C/S1+APIC1) + RE1=$81.67 + OCI=$50
C/S1+APIC1 = $103.68
Inc Equity = (C/S1+APIC1) – (C/S0+APICo) = $103.68 - $29 = $74.68 $135.61
Inc Debt = $135.61 - $74.68 = $60.93
Given above split ($135.61 raised via $74.68 in new equity and $60.93 in additional debt), how would that change F/S?
- You are still raising $135.61, but you are using a mix of equity and debt.
- Cash balance should be same (assume I/E doesn’t change due to Debt inc)
- Cash Flow yields same ∆ Cash (assume I/E doesn’t change due to Debt inc), but FCF is tweaked
- Net Income Statement does not change (assume I/E doesn’t change due to Debt inc)
 FL1=1.44 FL1=1.82
SC #4 Keeping Dm%
Cash $12.00 $178.67 Cash $12.00 $178.67
A/R $37.50 $50.37 A/R $37.50 $50.37
Inv. $55.00 $81.61 Inv. $55.00 $81.61
PP&E Net $120.00 $127.12 PP&E Net $120.00 $127.12
OLTA $6.25 $6.25 OLTA $6.25 $6.25
TA $230.75 $444.01 TA $230.75 $444.01

A/P $2.50 $4.48 A/P $2.50 $4.48

STB $6.25 $11.19 STB $6.25 $11.19
LTD $100.00 $131.86 LTD $100.00 $192.79
OLTL $0.00 $0.00 OLTL $0.00 $0.00
Total Liabs. $108.75 $147.53 Total Liabs. $108.75 $208.46
OCI $50.00 $50.00 OCI $50.00 $50.00
C/S + APIC $29.00 $164.61 C/S + APIC $29.00 $103.68
R/E $43.00 $81.87 R/E $43.00 $81.87
Total Equity $122.00 $296.48 Total Equity $122.00 $235.55
Total L+E $230.75 $444.01 Total L+E $230.75 $444.01
Check Assets - Liabilities - Equities = 0 $0.00 $0.00 Check Assets - Liabilities - Equities = 0 $0.00 $0.00

Sales $250.00 $447.73 Sales $250.00 $447.73

COGS $147.00 $267.14 COGS $147.00 $267.14
Gross Profit $103.00 $180.59 Gross Profit $103.00 $180.59
Depreciation Expense $9.00 $10.79 Depreciation Expense $9.00 $10.79
Other Expenses $55.00 $99.95 Other Expenses $55.00 $99.95
EBIT $39.00 $69.85 EBIT $39.00 $69.85
Interest Expense $3.50 $5.06 Interest Expense $3.50 $5.06
Taxes (at 40%) $14.20 $25.91 Taxes (at 40%) $14.20 $25.91
Net Income $21.30 $38.87 Net Income $21.30 $38.87

Net Income (or earnings) $38.87 Net Income (or earnings) $38.87
+ Depreciation $10.79 + Depreciation $10.79
- Increases in Working Cap -$32.56 - Increases in Working Cap -$32.56
+/- other non-cash adjustments $0.00 +/- other non-cash adjustments $0.00
Total Operating CF's $17.10 Total Operating CF's $17.10

- PP&E Purchases -$17.91 - PP&E Purchases -$17.91

+ PP&E Sales $0.00 + PP&E Sales $0.00
+/- other investments $0.00 +/- other investments $0.00
Total Investments CF's -$17.91 Total Investments CF's -$17.91

+ Equity Issues (or - Equity repurchases) $135.61 + Equity Issues (or - Equity repurchases) $74.68
+ Debt Issues (or - Debt Pmts.) $31.86 + Debt Issues (or - Debt Pmts.) $92.79
- Dividends $0.00 - Dividends $0.00
Total Financing CF's $167.48 Total Financing CF's $167.47
Delta Cash $166.67 Delta Cash $166.67
Now, lets suppose that Dm% remains constant (as we just did), but your Financial Manager
tells you that she can only cover $91.08 of the $135.61 deficit. You need to come up with rest
If you need to come up with rest, you need to “Consume” less. Lets use the original
equation for Consumed Capital. Assume that Interest Expense rises from $5.06 to $6.87
Consumed Capital (Top Down) = COGS+SG&A+Inc WK+(CAPex+Dep)
Assume that you can’t change CAPex, so CAPex+Dep will remain the same as baseline

Thus, aforementioned means that you’ll need to lower COGS+SG&A+Inc WK by some amount
Lets assume that COGS drops 5%, SG&A drops 3.45%, Inv’s improve by $10.62 and that you
manage concessions with your providers to increase A/P to $6.72. In addition, you borrow
an additional $5.7 from original projection. Are these improvements enough???
COGS1x5% = $267.14x5% = $13.36
SG&A1x3.45% = $99.95x3.45% Net Income changes by
what was saved (net of Tax)
= $3.45 Op Improv’s
Inv Improvement = $10.62 and decreases by what I/E = $10.62 $35.54
increased by (net of tax)
A/Pnew – A/Porig = $6.72-$4.48 = $2.24
Relative STB increment = $16.89-$11.19 = $5.70
∆ Net Income = [($13.36+$3.45)-($6.87-$5.06)]x(1-40%) = $9.00
Improvements = $44.54
(CC1Orig-Op Improv’s)/FL0 - OCI1 -( RE1Orig + ∆NI) – [C/S0+APIC0]
, ∆ Equityinc = ($428.24-$35.54)/1.82-$50 -[$81.87 + $9]) - $29 = $45.95
, ∆ Debtinc = (FL0-1) x TE1REV - LTD0 = (1.82-1)x(29+45.95+90.87+50) -$100 = $76.94
What are the new Financial Statements???
Keeps FL1=FL0 and finances deficit with new capital Keeps FL1=FL0, finances deficit w/ Eff,PM improv’s, rest with new capital
Keeping Dm% Keeping Dm%
Cash $12.00 $178.67 Cash $12.00 $161.87
A/R $37.50 $50.37 A/R $37.50 $50.37
Inv. $55.00 $81.61 Inv. $55.00 $70.82
PP&E Net $120.00 $127.12 PP&E Net $120.00 $127.12
OLTA $6.25 $6.25 OLTA $6.25 $6.25
TA $230.75 $444.01 TA $230.75 $416.42

A/P $2.50 $4.48 A/P $2.50 $6.72

STB $6.25 $11.19 STB $6.25 $16.89
LTD $100.00 $192.79 LTD $100.00 $176.94
OLTL $0.00 $0.00 OLTL $0.00 $0.00
Total Liabs. $108.75 $208.46 Total Liabs. $108.75 $200.55
OCI $50.00 $50.00 OCI $50.00 $50.00
C/S + APIC $29.00 $103.68 C/S + APIC $29.00 $75.00
R/E $43.00 $81.87 R/E $43.00 $90.87
Total Equity $122.00 $235.55 Total Equity $122.00 $215.87
Total L+E $230.75 $444.01 Total L+E $230.75 $416.42
Check Assets - Liabilities - Equities = 0 $0.00 $0.00 Check Assets - Liabilities - Equities = 0 $0.00 $0.00

Sales $250.00 $447.73 Sales $250.00 $447.73

COGS $147.00 $267.14 COGS $147.00 $253.78
Gross Profit $103.00 $180.59 Gross Profit $103.00 $193.94
Depreciation Expense $9.00 $10.79 Depreciation Expense $9.00 $10.79
Other Expenses $55.00 $99.95 Other Expenses $55.00 $96.50
EBIT $39.00 $69.85 EBIT $39.00 $86.65
Interest Expense $3.50 $5.06 Interest Expense $3.50 $6.87
Taxes (at 40%) $14.20 $25.91 Taxes (at 40%) $14.20 $31.91
Net Income $21.30 $38.87 Net Income $21.30 $47.87

Net Income (or earnings) $38.87 Net Income (or earnings) $47.87
+ Depreciation $10.79 + Depreciation $10.79
- Increases in Working Cap -$32.56 - Increases in Working Cap -$13.83
+/- other non-cash adjustments $0.00 +/- other non-cash adjustments $0.00
Total Operating CF's $17.10 Total Operating CF's $44.83

- PP&E Purchases -$17.91 - PP&E Purchases -$17.91

+ PP&E Sales $0.00 + PP&E Sales $0.00
+/- other investments $0.00 +/- other investments $0.00
Total Investments CF's -$17.91 Total Investments CF's -$17.91

+ Equity Issues (or - Equity repurchases) $74.68 + Equity Issues (or - Equity repurchases) $46.00
+ Debt Issues (or - Debt Pmts.) $92.79 + Debt Issues (or - Debt Pmts.) $76.94
- Dividends $0.00 You consume $35.54 less!!! - Dividends $0.00
Total Financing CF's $167.47 $428.35 >> $392.81 Total Financing CF's $122.94
Delta Cash $166.67 Delta Cash $149.87
In last Ex, you (as Divisional Mgr) self-financed $44.54 of the $135.61 in Deficit by finding
ways to consume less (to wit, you sought Eff and PM improvements). The rest ($135.61-
$44.54=$91.081) you needed to get from Financial Manager. The former is financing of the
type “Short Term Financing”. The latter (dealt with Equity and LTD) is “Long Term Financing”

What if Dm% into the future is different than in the past (to wit, that FL1 is < or > than FL0)?

Then, you can simply project as we have done here. But, in valuing the Equity Market, you
do the following adjustment to the Debt you subtract (assuming constant growth of FCF’s):

Em = FCF1/(Rwacc-g) + EC0 – Eb0 x (FL1-1)

We do this b/c the Debt could be higher (FL1>FL0) or lower (FL1<FL0) than what is currently
reflected on the Balance Sheet as of t=0. Why do this? Because if Dm% is higher or lower,
your Rwacc reflects that higher or lower level of leverage (so an adjustment of the amount of
Debt you subtract from the total valuation is thus needed to sync up LTD with Rwacc)

Note: 1. This additional $91.08 is from the result of adding the $45.95 in new Equity and the additional $45.08 in LTD over the initial LTD at t=1 of $131.86
 Effect of changing
Financial Leverage on Rwacc
If you believe that benefits of issuing debt (due to its tax shield, which tends to lower Rwacc)
are ever accruing, think twice. The more debt, the riskier both Equity and Debt become
Rwacc = Re x Em% + Rd x Dm% x (1-T)
Rwacc = Re x (1-Dm%) + Rd x Dm% x (1-T)
Rwacc = [Rf + Be x (Rm-Rf)] x (1-Dm%) + Rd x Dm% x (1-T)
Rwacc = [Rf + (Ba/Em%) x (Rm-Rf)] x (1-Dm%) + Rd x Dm% x (1-T), because Be = Ba/Em%1
- The more debt, the lower Em% is.
- The lower Em%, the higher Be is (Be = Ba/Em%) and the higher Re will be too!
- More debt increases both Re and Rd (the “drunker” the company, the worse for everyone) 2
- B/C of aforementioned, with more LTD, Rwacc drops until a point, but then Rwacc increases
Example:
Before capital issued to cover deficit:Be=1.33, Rf=2% and Rm-Rf=6%, Rd=3.5% and Dm%=21%
Re = 2%+1.33 x 6% = 10%
Rwacc=8.33% = 10% x (1-21%) + 3.5% x 21% x (1-40%), with T=40%
Rd = 3.50%
For case when you financed the deficit as all-equity, the Dm% changed from 21% to 13%
Re = 2% + [1.33 x (1-21%) / (1-13%)] x 6% = 9.24% Rwacc=8.294%=9.24% x (1-13%)
Rd = 3.20% (assume credit agency gives better rating due to lower Dm%) + 3.2% x 13% x (1-40%)
Lets assume (no financial statements are shown for this Ex) that the Dm% goes to 9%
Re = 2% + [1.33 x (1-21%) / (1-9%)] x 6% = 8.63% Rwacc=8.290%=11.0% x (1-30%)
Rd = 3.075% (assume credit agency gives better rating due to lower Dm%) + 3.075% x 30% x (1-40%)
Rwacc for a Dm%=5% (with an Rd=3.05%) = 8.297%
Rwacc = 8.296% = 8.64%x95%+3.05%x5%x60%
Note: 1. Copeland’s Beta of Assets, for constant Dm% and risk of debt varying in relation to the risk of the enterprise, is said to be equal to Be x Em% + Bd x Dm%, with Bd ~ 0 (so Ba=BexEm%)
2. While not discussed in detail here, Rd is CAPM based (Rd = Rf + Bdx(RM-Rf)). However, as Long Term Debt is not as “liquid”, we take credit agency ratings as the value for Bdx(Rm-Rf)
Rwacc is NOT a declining function, but rather a function that declines and then veers up!!!

Rwacc
9.800%

9.600%

9.400%

9.200%

9.000%

8.800%

8.600%

8.400%

8.200%
0% 5% 10% 15% 20% 25%
Dm%
Rwacc is NOT a declining function, but rather a function that declines and then veers up!!!

Rwacc Rwacc
9.800% 8.330%

9.600% 8.325%

8.320%
9.400%
8.315%
9.200%
8.310%
9.000%
8.305%
8.800%
8.300%
8.600%
8.295%
8.400% 8.290%

8.200% 8.285%
0% 5% 10% 15% 20% 25% 0% 5% 10% 15% 20% 25%
Dm% Dm%
 Effect of changing
Financial Leverage on Rwacc
VIDEO SKETCHES
1 2

3 4

5 6