The corporation financial manager is concerned with selecting the best possible source of financing based on the facts of the situation. This post describes various circumstances in which a particular financing source is most suited.
1. Issuing Debt or Preferred Stock
A Corporation is considering issuing either debt or preferred stock to finance the acquisition of a plant costing $1.3 million. The interest rate on the debt is 15 percent. The dividend rate on the preferred stock is 10 percent. The tax rate is 46 percent.
The annual interest payment on the debt is:
15% x $1,300,000 = $195,000
The annual dividend on the preferred stock is:
10% x $1,300,000 = $130,000
The required earnings before interest and taxes to meet the dividend payment is:
$130,000 / (1 – 0.46) = $240,741
If the company anticipates earning $240,741 without difficulty, it should issue the preferred stock.
2. Refinancing: Equity or Long-term Debt Securities
A Corporation has previously used short-term financing. It is now considering refinancing its short-term debt with equity or long-term debt securities. The financial manager decided to list the factors that should be taken into account when selecting an appropriate means of financing. These factors are:
- The costs of the instruments
- The company’s earnings compared to the cost of debt and preferred stock
- The recurrence in sales and earnings
- The degree of financial leverage
- The maturity and degree of success of the firm
- The degree of dilution in voting control to be tolerated
- The firm’s solvency status
3. Financing High-risk Industry with High Debt/Equity Ratio
A Corporation has sales of $30 million a year. It needs $6 million in financing for capital expansion. The debt/equity ratio is 68 percent. The company is in a risky industry, and net income is not stable year to year. The common stock is selling at a high P/E ratio relative to the competition. Under consideration is either the issuance of common stock or a convertible bond.
Because the company is in a high-risk industry and has a high debt/equity ratio and fluctuating earnings, the issuance of common stock is preferred.
4. Stock Issuance or Debt Financing
A Corporation is a mature company in its industry. It has a limited ownership. The company has a fluctuating sales and earnings stream. The firm’s debt/equity ratio is 70 percent relative to the industry standard of 55 percent. The after-tax rate of return is 16 percent. Since the corporation’s is a seasonal business, there are given times during the year when its liquidity position is deficient. The company is undecided on the best means of financing.
Preferred stock is one possible means of financing. Debt financing is not recommended because of the already high debt/equity ratio, the variability in earnings, and the poor liquidity position. Because of the limited ownership, common stock financing may not be appropriate since this would dilute the ownership.
5. Fund Raising for a New Contract
A new company is established and it plans to raise $15 million in funds. The company anticipates that it will obtain contracts that will provide $1,200,000 a year in before-tax profits. The firm is considering whether to issue bonds only or an equal amount of bonds and preferred stock. The interest rate on AA corporate bonds is 12 percent. The tax rate is 50 percent.
The firm will probably have difficulty issuing $15 million of AA bonds because the interest cost of $1,800,000 (= 12% x $15,000,000) associated with these bonds is greater than the estimated earnings before interest and taxes.
The issuance of debt by a new company is a risky alternative.
Financing with $7.5 million in debt and $7.5 million in preferred stock is also not recommended.
While some debt may be issued, it is not feasible to finance the balance with preferred stock. In the event that $7.5 million of AA bonds were issued at the 12 percent rate, the company would be obligated to pay $900,000 in interest. In this event, a forecasted income statement would look as follows:
Earnings before interest and taxes $1,200,000
Interest $ 900,000
Taxable income $ 300,000
Taxes $ 150,000
Net income $ 150,000
The amount available for the payment of preferred dividends is only $150,000. Hence, the maximum rate of return that could be paid on $7.5 million of preferred stock is:
$150,000 / $7,500,000 = 0.02
Stockholders would not invest in preferred stock that offers only a 2 percent rate of return. The company should consider financing with common stock.
6. Financing for Plant asset Purchase
A Corporation wishes to construct a plant that will take about 1.5 years to build. The plant will be used to manufacture a new product line, for which the corporation anticipates a high demand. The new plant will significantly increase the company’s size.
The following costs are expected to occur:
- The cost to build the plant, $800,000
- Funds required for contingencies, $100,000
- Annual operating costs, $175,000
The asset, debt, and equity positions of the firm are similar to industry standards. The market price of the firm’s stock is less than it should be, considering the future earning power of the new product line.
What would be an appropriate way to finance the construction?
- Because the market price of stock is less than it should be and considering the potential of the product line, convertible bonds and installment bank loans might be appropriate means of financing, since interest expense is tax deductible.
- Further, the issuance of convertible bonds might not require repayment, since the bonds are likely to be converted to common stock because of the firm’s profitability. Installment bank loans can be gradually paid off as the new product generates cash inflow. Funds required for contingencies can be in the form of open bank lines of credit.
- If the market price of the stock was not at a depressed level, financing through equity would be an alternative financing strategy.
8. Financing for Expansion [Acquisition] Purposes
ABC Company wishes to acquire XYZ Corporation but has not decided on an optimum means to finance the purchase. The current debt/equity position is within the industry guideline. In previous years, financing has been accomplished through the issuance of short-term debt. Earnings have shown instability over the years and consequently the market price of the stock has fluctuated. At present, however, the market price of stock is strong. The company’s tax bracket is low.
The acquisition should be financed through the issuance of equity securities for the following reasons:
- The market price of stock is presently at a high level.
- The issuance of long-term debt will result in more instability in earnings due to high fixed interest charges. As a result, there will be greater instability in the company’s stock price.
- The issuance of more debt will cause the firm’s debt/equity ratio to rise above the industry norm. This will adversely affect the company’s cost of capital and availability of financing.
- Because it will take a long time to derive the funds necessary for the acquisition cost, short-term debt should not be issued. If short-term debt is issued, the debt would have to be met prior to the receipt of the return from the acquired business.
9. Financing for Capital Expansion Program
Lie Dharma Corporation wishes to undertake a capital expansion program and must, therefore, obtain $7 million in financing. The company has a good credit rating. The current market price of its common stock is $60. The interest rate for long-term debt is 18 percent. The dividend rate associated with preferred stock is 16 percent, and Lie Dharma’s tax rate is 46 percent.
Relevant ratios for the industry and the company are:
Industry Lie Dharma
Net income to total assets 13% 22%
Long-term debt to total assets 31% 29%
Total liabilities to total assets 47% 45%
Preferred stock to total assets 3% 0
Current ratio 2.6 3.2
Net income plus interest to interest 8 17
Dividend per share is $8, the dividend growth rate is 7 percent, no sinking fund provisions exist, the trend in earnings shows stability, and the present ownership group wishes to retain control.
The cost of common stock is:
(Dividends per share / Market price per share) + dividend growth rate
($8/$60) + 0.07 = 20.3%
The after-tax cost of long-term debt is 9.7 percent (18% x 54%).
The cost of preferred stock is 16 percent.
How should Lie Dharma finance its expansion?
The issuance of long-term debt is more appropriate for the following reasons:
- Its after-tax cost is the lowest.
- The company’s ratios of long-term debt to total assets and total liabilities to total assets are less than the industry average, pointing to the company’s ability to issue additional debt.
- Corporate liquidity is satisfactory based on the favorable current ratio relative to the industry standard.
- Fixed interest charges can be met, taking into account the stability in earnings, the earning power of the firm, and the very favorable times-interest-earned ratio. Additional interest charges should be met without difficulty.
- The firm’s credit rating is satisfactory.
- There are no required sinking fund provisions.
- The leveraging effect can take place to further improve earnings.
In the case that the firm does not want to finance through further debt, preferred stock would be the next best financing alternative, since its cost is lower than that associated with common stock and no dilution in the ownership interest will take place.