External sources for financing Pearlparadise.com

Let’s use Portia as an ongoing example. Portia can consider using external financing, which refers to funds invested by outside investors and lenders. External financing is divided into equity and debt financing. Portia can either borrow money with the agreement to repay the borrowed sum plus interest or can obtain funds in exchange for equity, or use a combination of equity and debt financing.

Portia can consider debt as a source of external financing. Debt financing increases her financial risk because debt must be repaid regardless of whether or not the firm makes a profit. If debt is not repaid according to an agreed upon schedule, creditors may even force the enterprise into bankruptcy. Alternatively, equity investors are not entitled to more than what is earned by the enterprise.

When borrowing from the bank, an entrepreneur has number of options. The following types of loans are generally available:

Lines of credit – this is when bank agrees to make money available to the business. Agreement is made for up to a certain amount and is not guaranteed, but only in place if the bank has sufficient funds available. Such agreement is generally made for a period of 1 year.

Revolving credit agreement – this is similar to the lines of credit but the amount is guaranteed by the bank. A commitment fee of less than 1% of the unused balance is generally charged. Therefore, such arrangement is generally more expensive for the borrower.

Term loans – such loans are generally used for the financing of equipment. The loan is generally corresponds to the useful life of the equipment.

Mortgages – such loans are long-term loans and are available for purchase of the property which is used as collateral for the loan.

Portia can also consider equity financing. Private equity investors include venture capital firms and business angels. Venture capital firms raise a fund and then select portfolio of businesses in which to invest. Portfolios generally include start ups and existing businesses.

In exchange for investment, venture capital firms obtain partial ownership of the business. Convertible preferred stock or convertible debt is usually preferred. This is because the venture capital firm would like to have the senior claim on assets in case of liquidation but still wants to have an option to convert it to common stock if the business becomes successful.

Business angels, which are also referred to as informal venture capital, are wealthy private individuals who invest in the firms in their individual capacity. A very small percentage of start ups manage to get such funding. Therefore, entrepreneurs should have other options available as well.

There are also government supported financing options available to Portia which are specific to Portia’s location.

Further, Portia can use personal sources of funds. The “personal” sources could be personal savings, credit cards, borrowing from friends and relatives or any other way of obtaining money such as selling an asset, such as a car or a summer house, to free up funds for investment in the enterprise.

Personal savings are usually the leading source of “personal” funds. Credit cards are often used but needed to be used with extreme caution as interest rates on outstanding amounts can be incredibly high.

Borrowing from friends and family is also very tricky and should be done with extreme care. If Portia’s business fails or does not perform as expected and money is not repaid when agreed than it can destroy or severely damage relationships. When borrowing from friends and family, it is a good guideline to ensure that it is seen as an investment rather than a gift by the lending side of the transaction. An agreed upon deal should be put in writing since memory is not always reliable. Moreover, the amount borrowed should be repaid as soon as possible.

Overall, Portia has a number of the sources of external financing to choose from. Portia needs to evaluate upsides and downsides of each option and consider all options in light of the unique situation of the business to choose the best option or combination of options.

 

Leveraged Buyouts (LBOs)

Leveraged buyouts (LBOs) are also called “bootstrap” transactions or highly-leveraged transactions (HLT). It occurs when a lot of debt, which is also referred to as leverage or borrowing, is used to acquire an organization or controlling percentage of shares of the organisation. As much as 90% or more of debt is used to finance a leveraged buyout.

The assets of the target company are typically used as collateral to finance the merger. Leveraged buyouts often involve situations when a public company is taken private. LBOs are examples of financial mergers.

Due to the nature of the acquisition, certain organizations are especially attractive candidates for leveraged buyouts. Such characteristics include under priced stock, healthy liquidity position, low debt level, inefficient current management of the organization which can be rectified by the new owners, consistent stable earnings of the target company, strong cash flow or the possibility of stronger cash-flows and a good position within the industry and availability of assets to account for sufficient collateral.

Repurchase of stock is sometimes undertaken by companies to decrease attractiveness of the company as a leveraged buyout target. Takeovers can be attractive due to a company’s liquidity position. If a company has a lot of cash, it can be used to cover all or part of the debt undertaken to finance the acquisition. By using available cash to repurchase stock, a firm decreases its attractiveness as a takeover target. Moreover, repurchase of shares increases the price per share which makes takeover more expensive.

Another strategy that management of the target company may use to protect itself against hostile takeover via leveraged buyout is defensive acquisition. The purpose of such an action is for the target company to make itself less attractive to the acquiring company. In such situations, the target company will acquire another company as a defensive acquisition and finance such an acquisition through debt. Due to increased debt of the target company, the acquiring company, which previously planned the hostile takeover, may lose interest in acquiring a highly leveraged target company. Before a defensive acquisition is undertaken, it is important to make sure that such action is better for shareholders’ wealth than a merger with acquiring company which pursues hostile takeover.

The nature of leveraged buyouts changed over the last 30 years. Whereas before, LBOs were mostly used to finance hostile takeovers, currently leveraged buyouts are predominantly used to finance management buyouts.

 

Financial leverage

Financial leverage is the relationship between operating profit and EPS (earnings per share). In short, it measures the level of debt. It is a measure of how the potential use of fixed financial costs (e.g. interest on debt) can enlarge the effect that change in operating profit (EBIT) has on EPS (earnings per share).

When does a firm have financial leverage?

If a firm has mixed financial costs, it has financial leverage. Due to financial leverage (existence of fixed financial costs), any increase in EBIT will result in even larger increases in EPS and any decrease in EBIT will result in even larger decreases in EPS.

How to calculate degree of financial leverage (DFL) of the firm?

To calculate degree of financial leverage, which is just a way to measure financial leverage of the firm, we can follow the following formula:

DFL =% change in EPS/% change in EBIT

Therefore, if the degree of financial leverage is greater than 1, then financial leverage exists (which is the case as long as the company has fixed financial costs). Also, any increase in financial leverage results in an increase in risk and any decrease in financial leverage results in a decrease in risk.

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Cost of long term debt

The first long term source of finance that we consider is the cost of long term debt, which is usually the cheapest of the long-term sources of finance. The majority of long term debt of large corporations is the result of issuing bonds.

Flotation cost


Companies that issue bonds have to take into account the flotation cost, which is the complete cost the company has to incur to issue and sell a security, such as common stock, preferred stock and bonds. This cost reduces the company’s net proceeds from issuing security.

Flotation cost consists of underwriting and administrative costs. Underwriting costs are payment to investment bankers for their services and administrative costs are costs other than the underwriting costs of issuing bonds.

Finding the before-tax cost of long-term debt (rd)


To find the after-tax cost of long term debt, we first need to find the before-tax cost of long term debt (rd). As mentioned above, the majority of long term debts of large corporations are the result of issuing bonds. By using a financial calculator, we can find the before tax cost of a bond (cost of long-term debt).

THE CALCULATION FOLLOWS:

FV – (future value of the bond which refers to its par value, which is also called the face value, and is usually $1,000)

PV – the value of the bond today at which it is sold (after deducting the flotation cost)

PMT – payment on the bond (for example, at 8% coupon interest rate a bond issuer will have to make annual payments of $80 if the par value is $1,000). Payments can also be made more frequently, such as semi-annually or even monthly, but in such a case we need to adjust the amount of payment and number of periods.

For example, if payment is made semi-annually, we will need to divide $80 by 2 and we will need to multiply number of periods by 2.

N – Number of periods

Calculate I – the cost of the bond (for the bond’s issuer it is the cost to maturity of the cash flows, for the bond’s holders it is the return they earn on buying and holding this bond to maturity). Within the context of our discussion, it is also the before-tax cost of long-term debt.

Note that if the net proceeds from the sale of the bond is the same as the face value of the bond than the before-tax cost of long-term debt will be equal to the coupon interest rate. For example, at 8% coupon interest rate, the par value of $1,000 and net proceeds of $1,000 (no flotation costs), the before-tax cost of long-term debt will equal 8%.

Finding the after-tax cost of long-term debt


After we found the before-tax cost of long term debt, we need to find the after-tax cost of long term debt. To do so all we need to do is to multiply the before-tax cost of long-term debt by (1-T), where T stands for the tax rate.

THEREFORE:

ri = rd * (1-T)

EXAMPLE:

If the before-tax cost of long term debt is 10% and tax rate is 28% then the calculation will be as follows:

Ri =10% * (1-.28)

Ri =10% * .72

Ri = 7.2%

Test yourself


You need to calculate the after-tax cost of a 30-year bond. The coupon interest rate is 10%, the par value is $1,000 and the bond is currently selling at $950.

SOLUTION:

PV: -950

FV: 1,000

PMT: 100

N: 30

I: 10.56%

Note: If you struggle with a calculation, read using a financial calculator article for some simple tips on using a financial calculator.

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Capital structure decisions analysis with debt ratios

When analyzing capital structure decisions, external stakeholders can obtain an approximate idea of the capital structure of the particular firm by using information in the firm’s financial statements to calculate various debt ratios.

When analyzing capital structure decisions of firms as outsiders, we need to consider two types of debt measures:

The first type of debt ratio measures the degree of indebtedness. This refers to how much debt the firm has relative to other balance sheet’s amounts. The debt ratio will measure the degree of indebtedness.

The second type of debt ratio measures the ability to service debts. This type of debt ratios measures the ability of the business to meet its obligations associated with debt, as they come due. Times Interest Earned Ratio and Fixed Payment Coverage Ratio will be considered to measure the ability to service debts.

Both techniques are very simple to use and effective at analysing capital structure decisions.

Measuring the degree of indebtedness


THE DEBT RATIO

A direct measure of debt is a debt ratio. Debt ratios provide direct information on the financial leverage of an enterprise. Debt ratios measure how many of the firm’s assets are financed by debt. The higher the debt ratio, the higher the degree of financial leverage (amount of debt) and the higher the risk. The formula for the debt ratio is as follows:

Debt ratio=Total liabilities/Total assets

Example:

For example, assume that ABC’s total liabilities are $1,700,000 and total assets are $4,000,000.

The debt ratio of ABC is as follows: $1,700,000/$4,000,000=42.5%

This means that ABC’s capital structure is 42.5% of debt and 57.5% of equity.

Measuring the ability to service debts


TIME INTEREST EARNED RATIO (INTEREST COVERAGE RATIO)

The Times Interest Earned Ratio (TIER or Interest Coverage Ratio) measures the ability of the enterprise to meet its financial obligations (interest payments on debt that come due).

When analyzing capital structure decisions, we can use the Times Interest Earned Ratio as an indirect measure of the level of debt in the firm’s capital structure. Commonly, the lower the Times Interest Earned Ratio the higher the degree of financial leverage (amount of debt) and the higher the risk.

The formula for the Times Interest Earned Ratio is as follows:

Times Interest Earned Ratio =EBIT/interest charges

EBIT refers to the earnings before interest and taxes, which is also called operating profit (refer to the Income Statement format to see how it is calculated).

EXAMPLE:

Assume ABC Company has an operating profit of $550,000 and interest charges of $100,000.

The TIER of ABC is as follows:

$550,000/$100,000=5.5

It is generally advisable that the Times Interest Earned Ratio should be between 3 and 5.

ABC’s Times Interest Earned Ratio could be too high. It may be possible that the firm is unnecessarily careful in using debt as a source of capital. This means the risk taken may be lower than average, but so is the return.

When using the Times Interest Earned Ratio, it is important to remember that interest is paid with cash and not with income (since some income may still be in the form of accounts receivable). Therefore, the real ability of the firm to make interest payments may be worse than indicated by the Times Interest Earned Ratio. It is also important to remember that debt obligations include repayment of principal debt as well as payment of interest. The calculation above excludes the principal amount borrowed.

Generally, the higher the Times Interest Earned Ratio the lower the risk an enterprise will not be able to meet its contractual interest obligations on time. Therefore, generally, a higher Times Interest Earned Ratio is the better.

However, cognizance needs to be taken of the fact that the higher the Times Interest Earned Ratio, the lower the risk and lower the return. Therefore, at some point, the Times Interest Earned Ratio may be too high. This will occur if the business is unnecessarily careful with taking up debt as a source of financing, which results in very low risk but also a lower return. This is not aligned with the overall goal of the enterprise which is the maximization of the wealth of its shareholders.

FIXED PAYMENT COVERAGE RATIO

Fixed Payment Coverage Ratio measures the ability of the enterprise to meet all of its fixed-payment obligations on time. When analyzing capital structure decisions, we can use the Fixed Payment Coverage Ratio as an indirect measure of the level of debt in the firm’s capital structure. Commonly, the lower the Fixed Payment Coverage Ratio the higher the degree of financial leverage (amount of debt) and the higher the risk.

The formula for the Fixed Payment Coverage Ratio is as follows:

Fixed Payment Coverage Ratio = EBIT+LP/I+LP +((PP +PSD)*(1/1-T))

Where:

EBIT – earnings before interest and tax (operating profit)

LP – lease payments

I – interest charges

PP – principal payments

PSD – preferred stock dividends

T – tax rate

EXAMPLE:

Assume ABC Company has an operating profit of $550,000 and interest charges of $100,000. The lease payments are fixed at $20,000, principal payments are at $60,000 and preferred stock dividends are at $15,000. The corporate tax rate of ABC is 40%.

The Fixed Payment Coverage Ratio of ABC is calculated as follows:

= 550,000+20,000/100,000+20,000+((60,000+15,000)*(1/1-T))

= 570,000/120,000+((75,000)*1.67)

= 570,000/120,000+125,250

= 570,000/245,250

= 2.3

The Fixed Payment Coverage Ratio of ABC is 2.3. Since EBIT is more than two times larger than fixed-payment obligations, it appears that ABC is in a strong position to live up to its fixed-payment obligations as they come due. However, as with all financial ratios, Fixed Payment Coverage Ratio should be compared to industry average before any conclusions are drawn. Generally, the higher the Fixed Payment Coverage Ratio the lower the risk that enterprise will not be able to meet its fixed-payment obligations on time. Therefore, a higher Fixed Payment Coverage Ratio is the better.

However, as with Times Interest Earned ratio, cognizance needs to be taken of the fact that the higher the Fixed Payment coverage ratio the lower the risk and lower the return. Therefore, at some point, the Fixed Payment Coverage Ratio may be too high. This will occur if the business is unnecessarily careful with taking up more debt which results in a very low risk but also a lower return. This is not aligned with the overall goal of the enterprise which is the maximization of the wealth of its shareholders.

***

When analyzing capital structure decisions with the help of debt ratios, one should compare debt ratios of individual firms to industry averages. There is a large variability of debt ratios’ industry averages between industries. This is because different industries have different operations requirements. There is no one perfect ratio. Appropriate ratios to use should determined by the company in question, taking into account company’s ‘s strategy, operating environment, competitive environment and finances.

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Capital structure decisions

Capital structure decisions refer to the decisions businesses have to make with regards to the mix of financing they use. The mix consists of debt and/or equity as sources of capital. In other words, it is a structure of the liabilities and equity side of the balance sheet, excluding current liabilities. Enterprises usually try to maintain a certain optimal mix of financing (debt and equity), referred to as the target capital structure.

The modern approach to capital structures is largely influenced by the work of Franco Modigliani and Merton H. Miller. This is also known as the M and M, or MM work. Their work published in 1958 in American Economic Review (June 1958) entitled “The Cost of Capital, Corporation Finance, and the Theory of Investment” suggests that under condition of perfect markets, capital structure decisions do not affect the value of the firm. Any increase in Return on Equity goes hand in hand with increase in risk. Therefore, weighted average cost of capital (WACC) stays constant.

In their later work, Franco Modigliani and Merton H. Miller introduced taxes into the model. Their further conclusion was that if corporate taxes are present then the value of the enterprise will increase continuously as more debt is added to capital structure.

This is possible because debt interest payments are tax deductible. However, it is evident that personal taxes will decrease the advantage gained. As a result, it is still profitable to use debt financing. However, the advantage gained is lessened by the existence of personal taxes versus existence of just corporate taxes.

Theoretically, enterprises can increase the value of the firm by finding the optimum capital structure (mix of equity and debt). The optimum capital structure refers to capital structure decisions according to which the weighted average cost of capital is at its minimum value and, as a result, the value of the firm is maximized.

Therefore, the optimum capital structure is in line with the main objective of the business, which is the maximization of wealth of the owners of the business. However, it is important to note that the optimal capital structure exists only in theory.

Sources of capital


Sources of capital include debt and equity. Equity is further subdivided into preferred stock and common stock. In turn, common stock is even further subdivided into new common stock and retained earnings.

When making capital structure decisions, it is important to keep in mind that generally debt is the least expensive source of capital. This is due to the fact that the lender takes much less risk than suppliers of the equity capital. This is occurs because:

(1) Debt has obligatory scheduled payments. Whereas, equity suppliers, especially in case of common stock, will only be paid when company can afford to do so.

(2) In case of liquidation, lenders have priority claim on assets of the company over equity suppliers.

(3) If firm misses obligatory interest or principal payments, lenders can force the firm into bankruptcy. Therefore, lenders have more power in ensuring that payments will be made on time.

Moreover, interest on debt is tax deductible, which makes it an even cheaper source of capital for the firm. Overall, and as stated above, debt is generally the cheapest source of capital for the firm.

How capital structure decisions affect the risk of a company?


Enterprises deal with three types of risks: financial risk, business risk and total risk. The capital structure directly affects the financial and total risk of the firm.

FINANCIAL RISK – a chance that firm will not be able to meet its financial obligations, which can result in bankruptcy. Financial risk is directly affected by the firm’s capital structure (its mix of debt and equity financing). The more debt the firm uses in its capital structure mix, the higher the financial risk.

BUSINESS RISK – a chance that firm will not be able to cover its operating costs. There are three factors that affect business risk. These are an increase in the degree of operating leverage, revenue instability and cost instability. Capital structure decisions do not affect business risk.

TOTAL RISK – a combination of financial and business risk. Since capital structure decisions affect financial risk, the total risk is also affected.

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Debt-equity ratio analysis

Debt-equity ratio analysis is one of several debt ratio analyses. Debt ratios measure the degree or financial leverage of the firm. The more debt the firm uses, the higher its financial leverage, the higher its financial risk (the risk of bankruptcy) and the higher the potential returns.

It measures the degree of indebtedness of the enterprise. It measures how much of equity and how much of debt a company uses to finance its assets. It is also referred to as leverage or gearing.

The formula is as follows:

Debt-equity ratio = Total liabilities/Shareholders equity

This formula is sometimes presented simply as:

Debt-equity ratio = Debt/Equity

Example of a debt-equity ratio analysis


Assume Gold Co. currently has total debt of $1,000,000 and shareholders equity of $1,800,000. The debt-equity ratio for the Gold Company is conducted as follows:

$1,000,000/$1,800,000=0.56

The result is less than 1 and indicates that business uses mainly equity to finance its operations. The financial risk of Gold Company seems to be under control. However, it is possible that company may have lower than possible returns due to being too careful with using debt financing. However, a closer investigation is required before any conclusions can be made.

Things to note about this ratio


If the debt-equity ratio shows a result of less than one, then it means that equity is mainly used to finance operations. However, if the debt-equity ratio is more than one, then it means that the debt is mainly used for financing of operations. If the result of debt-equity ratio analysis is equal to one, then it means that a half of financing comes from debt and a half comes from equity.

The more debt compared to equity the firm uses in financing its assets, the higher the financial risk and the higher the potential return. Financial risk refers to the risk of the firm being forced into bankruptcy if the firm does not meet its debt obligations as they come due.

The results should be compared to industry averages, to the firm’s past ratio trends and to a similar analysis of leading competitors within the industry.

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The debt ratio

A direct measure of debt of the firm is the debt ratio. Debt ratio measures how many of the firm’s assets are financed by debt. The higher the debt ratio the higher the degree of financial leverage (amount of debt) in the capital structure of the enterprise and the higher the risk and potential return.

The formula for the debt ratio is as follows:

Debt Ratio = Total liabilities/Total assets

If the debt ratio is higher than 1 than it means that an enterprise has more debt than assets. If the debt ratio is lower than 1 than it means that an enterprise has more assets than debt.

EXAMPLE:

Assume that ABC’s total liabilities are $1,700,000 and total assets are $4,000,000.

The debt ratio of ABC is as follows: $1,700,000/$4,000,000=42.5%

This means that ABC’s capital structure is 42.5% of debt and 57.5% of equity.

Test yourself


Dillon Corporation has total liabilities of $4,000,000 and total assets of $5,500,000.

Required: Find the debt ratio of Dillon Corporation

Solution:

The ratio is calculated as follows:

$4,000,000/$5,500,000 = 73%

This means that Dillon Corporation’s capital structure is 73% of debt and 27% of equity. A debt ratio of 73% is generally considered to be a very high debt ratio and may indicate a problem of a very high indebtedness and very high financial risk. However, as with all financial ratios, the debt ratio of Dillon Corporation should be compared to the industry average before any conclusions are drawn.