The financing Decision

 Financing decisions are concerned with two

major issues
 Sources of funds
 Internal or External sources
 The types of instruments to issue
 The financing mix decision
 Short versus long term sources
 The amount to be raised from each source
 Decisions on the two issues are influenced by:
 The costs of the funds (for the different sources)
 The effect on the firm’s return and riskness
Lecture8_The Financing Decision and the Cost of Capital
November 1, 2023 1
 The financing Decision
 Financing decisions lead to a firm having a
certain financial structure
 Financial structure shows the way in which
firm’s assets are financed
 The firms mix of debt and equity financing
 The whole of the CAPITAL and LIABILITY side
 i.e. total liabilities, preferred stock and net worth
 Capital Structure is the permanent financing of
the firm represented by long-term debt,
preferred stock and net worth
 All short-term financing are excluded
Lecture8_The Financing Decision and the Cost of Capital
November 1, 2023 2
 The financing Decision
 Financing Decision is aimed at ensuring that
the firm uses optimal financing
 The firm should raise funds in such a manner that
the firm’s market value is maximized
 Is there optimal financing?
 Does optimal capital structure exist?
 Traditionalists
 Each firm has an optimal capital structure where
the firm’s cost of capital is minimized and/or the
firm’s value maximized
Lecture8_The Financing Decision and the Cost of Capital
November 1, 2023 3
 The financing Decision
 Traditionalists (cont)
 Financial manager should search for this optimal
capital structure
 The irrelevant capital structure model
 Championed by [Franco] Modigliani and [Merton] Miller
{MM}
 Optimal capital structure does not exist
 Any capital structure is as good as any other
 Financial managers should concentrate in
identifying investments that would have greater
impact on firm’s value
Lecture8_The Financing Decision and the Cost of Capital
November 1, 2023 4
 The financing Decision
 The irrelevant capital structure [MM] model is
based on some assumptions
 Perfect capital market
 Investors are rational [have rational expectations]

Lecture8_The Financing Decision and the Cost of Capital

November 1, 2023 5
 The financing Decision
 Financing decisions are sometimes more
complicated than investment decisions
 The variety of securities to sell is large and
continually expanding
 The number of financial institutions providing
financing is extensive
 The [financing] market is very competitive

Lecture8_The Financing Decision and the Cost of Capital

November 1, 2023 6
 The financing Decision
 In some ways financing decisions are easier
than investment decisions
 May be reversed more easily
 The level of competitiveness in the financial
markets is extensive hence reducing the chances of
making incorrect decision
 Prices, rates and terms are fairly determined
 The efficiency of the financial markets is
crucial in making financial decisions

Lecture8_The Financing Decision and the Cost of Capital

November 1, 2023 7
 Sources of Funds: Internal
 Internally generated funds come from firm’s
operation
 Commercial credit is an internal source of funds
 Issuing additional equity is not
 However, there is no clear cut distinction in some
cases
 Internally generated funds are assessed based
on firm’s cash flows
 Retained profit
 Non cash expenses (such as depreciation)
Lecture8_The Financing Decision and the Cost of Capital
November 1, 2023 8
 Sources of Funds: Internal
 For some firms, funds generated internally are
substantial
 Microsoft is a case in point
 Researches have shown that business (or
investment) growth rate is determined by the
growth of internally generated funds rather
than the quantity of positive NPV investments
 Managers that do not wish to be critically
monitored by the financial markets/institutions
rely mainly on internal funds
Lecture8_The Financing Decision and the Cost of Capital
November 1, 2023 9
 Sources of Funds: External
 External sources include
 Issuing additional equity
 To existing shareholders
 To outsiders (bringing-in additional/new
shareholders)
 Securing loans
 From financial institutions
 From other sources (including private party loan
arrangements)
 Issuing debt instruments
Lecture8_The Financing Decision and the Cost of Capital
November 1, 2023 10
 Sources of Funds: Equity
 Issuing additional equity is highly influenced by
the nature of the firm’s ownership
 Sole proprietorship
 Partnership
 Cooperative
 Corporation (limited liability entity)

Lecture8_The Financing Decision and the Cost of Capital

November 1, 2023 11
 Sources of Funds: Equity
Sole Partnership Cooperative Corporation
Proprietorship
Owners The manager Partners Members Shareholder
s
# Owners 1+family Few (2-20) Many Many

Managers/ NO NO (in NO (for small YES

Owners most ones);
separate? cases) Usually yes
for large ones
Liability Unlimited Unlimited LTD for most Limited

Lecture8_The Financing Decision and the Cost of Capital

November 1, 2023 12
 Sources of Funds: Ordinary Equity
 Ownership of ordinary shares confers rights on
ordinary shareholders on both an individual
and a collective basis. The rights include:
 The right to attend general meetings of their
company
 The right to vote on the election of the directors of
their company
 The right to vote on the appointment, remuneration
and removal of auditors

Lecture8_The Financing Decision and the Cost of Capital

November 1, 2023 13
 Sources of Funds: Ordinary Equity
 The rights available to shareholders (cont):
 The right to receive the annual accounts of their
company and report of its auditors
 The right to receive a share of any dividend
distributed
 The right to vote on important matters such as a
change in their company’s authorized share capital,
the repurchase of its shares, or a take-over bid
 The right to receive a share of any assets remaining
after their company has been liquidated
 The right to participate in anew issue of shares in
their company (the pre-emptive right)
Lecture8_The Financing Decision and the Cost of Capital
November 1, 2023 14
 Sources of Funds: Ordinary Equity
 Ordinary shareholders are the ultimate bearers
of the risk associated with the business
activities of the companies they own.
In the event of the company going into liquidation,
there is an order of precedence governing the way
in which the proceeds of liquidation are distributed
 The “creditor hierarchy” of claims settlement:
 1st – secured creditors (e.g. debenture holders and banks).
 They are entitled to receive in full both unpaid interest and the
outstanding principal.

Lecture8_The Financing Decision and the Cost of Capital

November 1, 2023 15
 Sources of Funds: Ordinary Equity
 The “creditor hierarchy” of claims settlement (cont):
 2nd – unsecured creditors (e.g. suppliers of goods and
services)
 3rd – Ordinary shareholders.
 They are not entitled to receive any of the proceeds of liquidation
until the amounts owing to creditors, both secured and
unsecured, have been satisfied in full.
 Ordinary shareholders are at the bottom of the
“creditor hierarchy”
 they carry the very real risk of receiving nothing at
all in the event of liquidation.
 This is especially true because liquidation is likely to be the
consequence of a protracted period of unprofitable trading

Lecture8_The Financing Decision and the Cost of Capital

November 1, 2023 16
 Sources of Funds: Ordinary Equity
 However, it is possible, because the claims of
creditors are fixed in nature, ordinary
shareholders have the possibility of making
substantial gains from the proceeds of
liquidation
 The high risk ordinary shareholders carry
means they will expect in compensation the
highest return
 the cost of equity will invariably be higher than the
cost of debt
Lecture8_The Financing Decision and the Cost of Capital
November 1, 2023 17
 Sources of Funds: Additional Equity
 To existing owner (s), issuing additional equity
may have a DILUTION effect
 In general, dilution refers to the extent in
which ‘power’ or ‘value’ of the existing owners
is affected
 Control (voting rights etc), price dilution etc.
 Dilution often changes the required rate of return
on equity
 Issuing additional equity needs the consent of
(approval from) the existing owners

Lecture8_The Financing Decision and the Cost of Capital

November 1, 2023 18
 Issuing equity securities in the
financial markets
 Primary market – the market for issues of
new securities
 Documentations when issuing additional
securities
 Prospectus
 The purpose of raising funds by issuing the

securities (The planned use of the funds)

 Memorandum and articles of association

Lecture8_The Financing Decision and the Cost of Capital

November 1, 2023 19
 Issuing equity securities in the
financial markets
 Two cases of issuing new equity securities:
 Going public – the first issue by a formerly
private company.
 Commonly known as Initial Public Offering – IPO
 Also known as an unseasoned issue
 Making a seasoned issue
 Issuing additional equity securities where there are
similar securities outstanding and trading in the market
 If a company wishes to issue new shares, it is required
by law to offer them first to its existing shareholders,
unless those shareholders have already agreed in a
meeting of the company to waive the right for a period

Lecture8_The Financing Decision and the Cost of Capital

November 1, 2023 20
 Issuing equity securities in the
financial markets
 IPOs are commonly underpriced.
 Such underpricing is reflected in the price jumps
when the securities are first traded
 Not all IPOs are underpriced
 Some go down in price
 Some are undersubscribed
 New issues are typically marketed by
investment bankers
 Negotiated vs. Competitive Bid

Lecture8_The Financing Decision and the Cost of Capital

November 1, 2023 21
 Issuing equity securities in the
financial markets
 New issues can also be marketed through
private placements
 Sale to a limited number of investors
 Very active market for debt securities, but not active
for stock offerings
 Shelf registration is also used
 register securities and gradually sell them to the public
 A shelf registration has a “shelf life”
 The registration can not remain valid forever
 Conditions at the firm may change
Lecture8_The Financing Decision and the Cost of Capital
November 1, 2023 22
 Issuing equity securities in the
financial markets
 A seasoned issue can also be made as a
“right issue”
 Existing shareholders have a right to buy the new
shares
 The shares are (usually) sold at a price below the
current market price
 An issue of additional equity that is open to
the public can be under- or over-subscribed
 Over-subscription is when the securities applied
for are more than those that are on offer
 In an over-subscribed issue, allotment (rationing)
is often used to allocate the securities
Lecture8_The Financing Decision and the Cost of Capital
November 1, 2023 23
 Issuing equity securities in the
financial markets
 For a seasoned issue the dilution effect (on
the price) is the difference between the price
before the additional equity and the one after
 expressed as a percentage of the original price
 For a right issue, the estimated loss per share
due to dilution is the price of a right to buy
new shares contained in one existing share
 This right can be sold separately from the
underlying share

Lecture8_The Financing Decision and the Cost of Capital

November 1, 2023 24
 Sources of Funds: Debt
 Loans from financial institutions include:
 Overdraft
 Line of credit
 Term loan
 Short-, Intermediate-, Long-term
 Issuing debt instruments
 Short-term Securities: Commercial papers
 Long-term Securities: Bonds, Loan stocks,
Debentures

Lecture8_The Financing Decision and the Cost of Capital

November 1, 2023 25
 Sources of Funds: Debt
 Debt is something, which at some time, will
have to be repaid
 Interest
 capital payments
 Some other forms of repayment/compensations
 Some debts are “repaid” through conversion to equity

Lecture8_The Financing Decision and the Cost of Capital

November 1, 2023 26
 Sources of Funds: Debt
 Debt may come with some conditions
 Deeds, covenants
 A trust deed sets out the terms of the contract
between bondholders and the company
 Affirmative covenants
 Requirement to supply regular financial statements
 Terms of interest and principal payments
 Some fees that may be due to the lenders
 Details of what procedures are to be followed in the
event of default

Lecture8_The Financing Decision and the Cost of Capital

November 1, 2023 27
 Sources of Funds: Debt
 “Negative” covenants
 Limit on further debt
 Maintaining a certain capital structure
 Dividend level
 Limit on the disposal of assets
 The magnitude of the basic financial ratios which
have to be maintained
 Please read the first 10 pages of Chapter 10 of
M. D. Baisi’s Manual

Lecture8_The Financing Decision and the Cost of Capital

November 1, 2023 28
 The Cost of Capital
 The cost of capital is the opportunity cost of
capital for firm’s existing assets
 We use it to value new assets that have the same
risk as the old ones
 The cost of capital focuses on the firm’s long
term financing
 Long-term debt
 Equity
 F
 Financial
Lecture8_The Financing Decision and the Cost of Capital
November 1, 2023 29