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LEARNING PACKET
(FINMAN2) – (FINANCIAL MANAGEMENT)
Session 1, First Semester, SY 2020-21
I. CONCEPT NOTES
Overview
Working Capital Management and Finance
● Focused on the decision-making as to short investments and short-term financing
● While these may be important, the overall value of the shareholders’ wealth is not significantly
affected by short-term decision making but by the long-term ones
Capital Structure
• Composition of the total long-term capital employed in a firm
• Composed of the following sources:
✔ Long-term debt
✔ Preferred Stock
✔ Common Stock
Issuance of new shares
Retained Earnings
Goal of the financial manager- to be able to provide an optimal capital structure the considers all factors
that affects shareholder’s value while lowering the cost associated with its (cost of capital)
Weighing Schemes
• Book Value versus Market Value
✔ Book Values are based on accounting values
✔ Market Values are based on the market
● Yield-to-Maturity Method
✔ A calculation method that estimates the cost of using long term debt
✔ Ways on computing the YTM rate:
Using a spreadsheet or financial calculator
Interpolation
Approximation Formula:
P ar V alue − N et proceeds
Interest + N o. of P eriods
Cost of Long-term Debt = P ar V alue + N et P roceeds
2
Where:
▪ Interest is the payment from the stated rate in a given period
▪ Par Value is the total value issued and stated in the bond
▪ Net Proceeds is the total cash received from issuance less flotation costs (costs of
issuing and selling securities)
• After Tax Rate
✔ Since the cost of debt (interest) is a deductible expense in taxation, therefore, an after-tax
rate will be determined to know the true cost of long term debt
✔ Computed as:
After-tax Cost of Long-term Debt = YTM Rate x (1 – Tax Rate)
Stated Dividends
Cost of Preferred Stocks = N et P roceeds
Where:
▪ Stated Dividends – dividends stated in the stock certificate to be paid periodically
▪ Net Proceeds – cash received from issuance net of flotation costs
Amount of total capital that will act as threshold for when the company may use
retained earnings or instead issue new stocks
investment available f rom retained earnings
RE Breakpoint = weight or proportion of common equity
Indicates the limit of total capital needed where retained earnings can still be
used as source for common equity
Beyond the RE Breakpoint, company should already issue new common stock
Sources:
● Fundamentals of Financial Management by Van Horne, 13th edition
● Fundamentals of Financial Management by Brigham and Houston, 11th Edition
● Fundamentals of Corporate Finance by Berk, DeMarzo, and Harford, 4th Edition
II. CHECKING FOR UNDERSTANDING
Exercise 1. Currently, Warren Industries can sell 15-year, P1,000-par-value bonds paying annual interest
at a 12% coupon rate. As a result of current interest rates, the bonds can be sold for P1,010 each; flotation
costs of P30 per bond will be incurred in this process. The firm is in the 40% tax bracket.
1. Find the net proceeds from sale of the bond, Nd.
2. Use the approximation formula to estimate the before-tax and after-tax costs of debt.
3. Suppose instead that the interest is a semi-annual interest at the same coupon rate, what is the
after-tax cost of debt of the bonds?
Exercise 2. Your firm, People’s Consulting Group, has been asked to consult on a potential preferred stock
offering by Brave New World. This 15% preferred stock issue would be sold at its par value of P35 per
share. Costs incurred in relation to the issuance is P1 selling cost and P2 underwriting cost. Calculate the
cost of this preferred stock.
Exercise 3. Ross Textiles wishes to measure its cost of common stock equity. The firm’s stock is currently
selling for P57.50. The firm expects to pay a P3.40 dividend at the end of the year (2013). The dividends
for the past 5 years are shown in the following table:
Year Dividend
2012 3.10
2011 2.92
2010 2.60
2009 2.30
2008 2.12
Exercise 4. A consultant gathered the following data for the construction of the capital structure of a
certain company:
Historical Target
Book Values
Long-term debt 50,000 10,000
Preferred Stock 10,000 20,000
Common Stock 40,000 120,000
Market Values
Long-term debt 45,000 15,000
Preferred Stock 15,000 40,000
Common Stock 60,000 125,000
1. How many weighing schemes are available and what are these combinations?
2. What is the optimal capital structure?
Exercise 5. FIGHTING Manufacturing is interested in measuring its overall cost of capital. The firm is in
the 35% tax bracket. Current investigation has gathered the following data:
• Debt The firm can raise debt by selling P1,000-par-value, 8% coupon interest rate, 5-year bonds
on which annual interest payments will be made. To sell the issue, the bond should be sold for 4%
lower than its par. The firm must also pay flotation costs of P22 per bond.
• Preferred stock The firm can sell 12% (annual dividend) preferred stock at its P120-per-share
par value. The cost of issuing and selling the preferred stock is expected to be P4 per share.
• Common stock The firm’s common stock is currently selling for P60 per share. The firm expects
to pay cash dividends of P5 per share next year. The firm’s dividends have been growing at an
annual rate of 4%, and this rate is expected to continue in the future. The stock will have to be
underpriced by P3 per share, and flotation costs are expected to amount to P2.50 per share.
1. Calculate the individual cost of the following sources of capital. For common stock, provide for the
two possible costs of capital.
2. Optimal capital structure is 40% debt, 15% preferred stock and 45% common stock. Using the
following data, what is the cost of capital for the following capital needs?
a. P300,000
b. P800,000
c. P500,000
3. If optimal capital structure is instead 50% debt, 20% preferred and 30% common stock, what is
the cost of capital given the three individual assumptions?
III. ANALYSIS
1. Discuss the importance of having an optimal capital structure.
2. Why does the firm’s capital have a cost?
3. What is the difference of nominal interest rate and effective interest rate?
4. In what instances is preferred equity better than ordinary/common equity?
5. Compare the Cordon Growth Model and the CAPM approach in computing the cost of common
equity.
6. Why is retained earnings a cheaper alternative than issuance of new shares?
7. What drives companies to diversify the sources of their capital?
8. How is the retained earnings breakpoint used in making capital funding decisions?
IV. INTEGRATION
1. When you need a large sum of money to buy something, where do you commonly get your
funding?
2. When choosing different sources of funding, what are the factors that you consider?
V. INDEPENDENT LEARNING
PREPARED BY:
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[Course Code] Instructors