lecture no. 49 chapter 15 contemporary engineering economics copyright © 2010 contemporary...
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Lecture No. 49Chapter 15
Contemporary Engineering EconomicsCopyright © 2010
Contemporary Engineering Economics, 5th edition, © 2010
Chapter Opening Story Disney’s Shanghai Park Plan Advances
$3.59B investment in building a theme park in mainland China
Disney needs to find a way to finance this large scale project, if the project gets going.
Because of the size of financing involved, the firm financing method will affect the firm’s capital structure, the cost of capital , and financial risk.
Contemporary Engineering Economics, 5th edition, © 2010
Methods of FinancingEquity Financing – Capital is
coming from either retained earnings or funds raised from an issuance of stock.
Debt Financing – Money raised through loans or by an issuance of bonds.
Capital Structure – Well managed firms establish a target capital structure and strive to maintain the debt ratio.
Contemporary Engineering Economics, 5th edition, © 2010
Capital Structure
Debt
Equity
Equity FinancingFlotation (discount)
Costs: the expenses associated with issuing new securities
Types of Equity Financing:
Retained earnings Common stock Preferred stock
Contemporary Engineering Economics, 5th edition, © 2010
Example 15.1 Equity Financing by Issuing Common StockScientific Sports, Inc. (SSI) needs to finance $10 million to develop and produce a new metal golf driver.Share price for the new stock offering = $28Flotation cost = 6%of the issue priceQuestion: How many shares must SSI sell to net $10 million?
Contemporary Engineering Economics, 5th edition, © 2010
(0.06)($28)(X) = 1.68X
Sales proceeds – flotation cost = Net proceeds 28X – 1.68X = $10,000,000 26.32X = $10,000,000 X = 379,940 shares. 1.68(379,940) = $638,300
Debt FinancingBond Financing:
May incur flotation cost No partial payment of principal Only interest is paid each year
(or semi-annually) The principal (face value) is paid
in a lump sum when the bond matures
Term Loan: May involve an equal
repayment arrangement. May incur origination fee Terms negotiated directly
between the borrowing company and a financial institution
Contemporary Engineering Economics, 5th edition, © 2010
Example 15.2 Debt Financing by Issuing Bonds
Scientific Sports, Inc. (SSI) needs to finance $10 million by issuing a mortgage bond. Face value = $1,000 Market price = $985 Coupon rate = 12% interest payable annuallyFloatation cost = 1.8% of the issue priceQuestion: (a) Number of bonds to be sold to net $10 million? (b) the total annual interest payment
(a) To net $10 million, SSI would have to sell
$10,000,000/(1- 0.018) = $10,183,300
worth of bonds and pay $183,300 in flotation costs. Since the $1,000 bond would be sold at $985, a 1.5% discount, the total number of bonds to be sold would be
$10,183,300/($985) = 10,339.
(b) For the bond financing , the annual interest is equal to
$10,338,380 (0.12) = $1,240,606
Only the interest is paid each period, and thus the principal amount owed remains unchanged.
Contemporary Engineering Economics, 5th edition, © 2010
Capital Structure (Debt Ratio)Definition: The means by which a firm is financed.Mixed Financing: Capital is raised by borrowing from
financial institutions and by issuing stocks and/or using retained earnings.
Target Capital Structure: Set a target debt ratio by considering both business risk and expected future earnings.
Contemporary Engineering Economics, 5th edition, © 2010
Example 15.3 Project Financing Based on an Optimal Capital Structure
SSI’s capital structure = 0.50 Raise $5M by issuing common stock and $5M by issuing bonds at 12% interest. Floatation cost:
Stock: 8.1% Bond: 3.2%
Project Description: Life: 5 years Building: $3M Equipment: $6M Land: $1M Cash dividend: $2 per share Unit production cost: $50.31 Unit price: $250 Annual O&M cost: $600,000 Annual demand: 20,000 units Working capital: $500,000 Tax rate: 40%
Contemporary Engineering Economics, 5th edition, © 2010