Materials Conveyed for the Seminar on Financial

Management Class

By:

Prof. Dr. Eric Y Nasution

LONG-TERM FINANCING: TYPES, IMPACT ON FINANCIAL LEVERAGE, AND

COST OF CAPITAL@@

TYPES OF LONG-TERMFINANCING

1. LONG-TERM LOAN (fr the banking system)2. BOND PAYABLE (fr the capital market

system)3. LEASE PAYABLE (fr the financing company)4. PENSION FUNDS (fr the employees’ payroll)5. EQUITY FINANCING (fr the capital market

system) a. Initial public offering (IPO) Preferred +

common

b. Right offering

ASSETS LIABILITIES & EQUITY

Current assets xxxFixed assets (net) xxxInvestment (securities) xxxIntangible assets xxx

INVESTMENT FUNCTION

Current liabilities xxxLong-term debt:•Investment loan xxx•Bonds payable xxx•Lease payable xxx•Pension funds xxx Total long-term debt xxxStockholders’ equity:*Preferred stock xxx*Capital stock xxx*Retained earnings xxx FINANCING FUNCTION

INCOME STATEMENT Leverage interpretation

Sales xxx Cost of goods sold xxxGross profit xxx Selling, general & administrative xxxOperating profit (ebit) xxx Interest expenses xxx Other expenses /(income) xxx Total financing & other cost xxxProfit before tax xxx Income tax xxxNet profit xxx EPS (us $) $$$ Dividend (% Pay Out) $$$ OPERATIONAL FUNCTION

OPOPOP OPERATING LEVERAGEOP FIN FIN FIN FIN FINANCIAL LEVERAGE FIN FIN FIN

OPERATING LEVERAGE FINANCIAL LEVERAGE

•Break-even point Sales•Control Fixed cost •DOL % ebit chg./% sales chg.•Formula Fixed cost/% margin contribution (income)•Decision (1) Strategic volume and selling price (2) Reducing selling price

•Break-even point EPS for a certain level of ebit•Control Interest cost•DFL% EPS chg./% ebit chg.•Formula (ebit-interest)(1-tax) for debt and equity alternatives*Decision (1) Debt: If break-even ebit < ebit normal, and (2) Equity: If break-even ebit > ebit normal

LONG-TERM DEBTS: Bond payable $ 20 m Stockholders’ equity 80 m * Capitalization $ 100 m * Outstanding shares = 40 m

THE FIRM AIMS TO RAISE $ 15 m:1st Alt: Addtl bond at 10% p.a.2nd Alt: Addtl shares at $ 1.5/shareIncome tax is assumed at 40%.

COSTING OF BOTH ALTERNATIVES:Bond 10% interest or $ 1.5 m

Equity $ 15 m : $ 1.5 or addtl shares of 10 m.

FORMULA APPLIED:(ebit – interest) (1 – t) = (ebit – interest) (1 – t) outstanding shares outstanding shares

and we will derive the ebit at break-even EPS

(ebit – interest expense) x (1 – income tax) : o/s shares

EQUAL TO (ebit - interest expense) x (1 – income tax) : o/s

shares (ebit – $ 1.5 m) x (1 – 40%) : 40 million shares

= (ebit – 0) x (1 – 40%) : (40 million + 10

million) 30 ebit – 45 = 24 ebit 6 ebit = 45 ebit = $ 7.5 million

DEBT ALTERNATIVE:k = 10% p.a.

EQUITY ALTERNATIVE: Price $ 1.5/sh

ebit 7.5Less Interest expense ( 1,5 )Profit before tax 6.0Less income tax (40%) 2.4Net profit 3.6 O/s shares (million) 40 EPS – In US$ 0.09

ebit 7.5Less Interest expense ( 0 )Profit before tax 7.5Less income tax (40%) 3.0Net profit 4.5 O/s shares existing (million) 40 additional (million) 10 Total o/s shares 50 EPS – In US$ 0.09

Description NORMAL SCENARIO

B/E EBIT SCENARIO

Sales Cost of salesGross profit SGA expensesOperating profit (ebit)

$ 60.0 m 32.0 m 28.0 m 10.0 m 18.0 m Normal ebit

$ 40.0 m 24.0 m 16.0 m 8.5 m 7.5 m Ebit at break-even EPS

DEBT STRATEGY EQUITY STRATEGY

Break-even EBIT

<

EBIT normal

Break-even EBIT

>

EBIT normal

Description EXISTING STRUCTURE

NEW STRUCTURE

CAPITALIZATION: Bonds payable

Stockholders’ equity

Total capitalization

$ 20 m

80 m

$ 100 m

$ 35 m

80 m

$ 115 m

DEBT(Kd) PREFERRED STOCK (Kp)

EQUITY (Ke)

Weight %

Cost of debt (Kd):•LT Credit Eff. interest•Bond ytm•Lease Amortization

Weighted average cost:LT Credit % x eff intBond % x ytmLease % x amortization

Weight %

Cost of pref. stock (Kp):

Dividend ratio Yield

Weighted average cost:

% x yield

Weight %

Cost of equity (Ke):

Dividend yield + g (growth)

Weighted average cost:

% x (dividend yield + g)

ICI 3-year Bond Issue, interest = 8% p.a. and fee = 6%.

Description Cfo CF 1-2 CF3 SumPV NPVFunds inflow 94 Yearly interest cost payment ( 8) ( 8) Principal repayment (call price) ( 105) 94 ( 8) ( 113) Factor = 11% 1.713 0.731 13.704 82.603 96.307 + 2.307 * Factor = 12% 1.690 0.712 13.520 80.456 93.976 – 0.024* Computed: $ 96,307 m - $ 94 m or $ 2.307 m

Interpolation: Ytm = 11% + (12% - 11%) x 2.307 : {2.307 – (- 0.024)} 11% + 0.99% atau 11.99% (using HP 12c calculator or Casio calculator: 94 CHS g CF0, 8 g PMT, 2 g Nj, 113 g PMT f IRR = 11.98%, difference due to decimal point)

SUSTAINABLE GROWTH CAPITAL ASSET PRICING MODEL

Objective: Growth is directed to the reinvestment of net income to sustain operation of the firm.

Formula: Ke = D/P + g, where D=dividend per share at CFo P=Price per share g= Growth rate, which is the reinvested ROE (1 – pay out) ROE=return on equity (%) pay out=% dividend payment (from the net income)

Objective: Growth is directed to the minimum income offered by the investment in fixed-income securities callled Treasury bill + risk premium.

Formula: Ke = Rf+beta(Rm – Rf), where Rf = Rate of return offered by the Treasury bill with less risk level beta= Risk level Rm=ROE of the industry

Ke = (EPS x 50% div pay out) : (EPS x P/E) (1 – fee) + ROE (1 – div pay out) Ke = ($ 0.1267 x 50% pay out) : ($ 0.1267 x 12)(1-3%) + 4.635% (1 – 50%) So the Ke = $ 0.0634 : $ 1.4748 + 2.318% 6.617%

Description 2008 2009 2010 2011 2012Projected net profit 0.325 1.105 2.041 3.725 5.915Dividend payment (pay out 50%) 0.163 0.553 1.021 1.863 2.958Retained earnings (RE) 0.162 0.552 1.020 1.862 2.957RE ending balance(2007=$ 5.063 m) 5.225 5.777 6.797 8.659 11.616Equity (ending bal 2007=$ 30.0 m)* 35.225 41.002 47.799 56.458 68.074Return on equity or ROE (%) ** 0.923 2.695 4.270 6.598 8.689*Average equity = $ 49.712 per year ** Average ROE = 4.635% per year

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Rf = 5%

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Rm=6,3%

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Beta=2

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ILLUSTRATIVE CASE, Inc. (ICI)

Least square computation for Beta

Year Rj Rm Jumlah Jumlah Rj x Jumlah (Jumlah Rm)

Rj x Rm jumlah Rm Rm 2 pangkat 2

2003 2,2 5,4 11,88 29,16

2004 4,2 5,8 24,36 33,64

2005 5,5 6,2 34,10 38,44

2006 7,6 7,8 59,28 60,84

Jumlah 19,5 25,2 129,62 491,40 162,08 635,04

SUSTAINABLE GROWTHFinancing Amount Weight Cost w a c c Computation Bond payable $ 5.0 m 9.1% 12.06% 1.097 9.1% x 12.06% Equity 49.7 90.9% 6.617% 6.015 90.9% x 6.617% Total capital 54.7 m 7.112

Ko (sustainable growth) = 7,112%

CAPITAL ASSET PRICING MODELFinancing Amount Weight Cost w a c c Computation Bond payable $ 5.0 m 9.1% 12.06% 1.097 9.1% x 12.06% Equity 49.7 90.9% 7.600% 6.908 90.9% x 7.600% Total capital 54.7 m 8.005

Ko (capital asset pricing model) = 8.005%

GOD BLESS YOU