Course Level: Beginner to Intermediate - No prior knowledge of capital management is required although some understanding of capital management will be helpful. Recommended for 2.0 hours of CPE. Course Method: Inter-active self study with audio clips, self-grading exam, and certificate of completion.

The Financing Decision

We have an understanding of what capital is (Chapter 1) and we understand how to calculatemaking financial decision and manage the cost of capital cost of capital (Chapter 2). Evaluating the project to make the right decision remainder of this course will focus on how to arrange financing; i.e. how do we actually raise capital. Evaluating the project to make the right decision financing decision must consider several factors. Some of these factors include:
  • Flexibility - Today's financing decisions will influence tomorrow's financing decisions. Ifmaking financial decision and manage the cost of capital business expects to raise capital in the future, it can not maximize its use of debt today. We need to provide a cushion so we can have flexibility with future financing decisions.
  • Risk - Financing withmaking financial decision and manage the cost of capital use of debt will increase risk. There is a limit to how much debt we can use to finance our business. Too much debt can ultimately lead to bankruptcy.
  • Income - Financing can influence earnings and thus affect return on equity. If we are concerned about returns to equity shareholders, then our financing decision will need to be adjusted. Income is also influenced by our ability to take advantage of tax deductions for interest on debt.
  • Control - If we have concerns about control overmaking financial decision and manage the cost of capital organization, then we have to consider how financing will change control. Financing decisions are connected to either ownership (equity) or creditors (debt).
  • Timing - Financing decisions need to be timed to take advantage ofmaking financial decision and manage the cost of capital marketplace. What type of securities should be sold? When should they be sold? What length of maturity should be used for debt financing?

Refinancing Risk

One of the objectives withinmaking financial decision and manage the cost of capital financing decision is to match the maturity of liabilities with the life expectancy of assets. This allows liabilities to be self-liquidating. Ifmaking financial decision and manage the cost of capital maturity of liabilities is less than the life expectancy of assets, then you face refinancing risk since you have to raise new capital to pay off liabilities. Ifmaking financial decision and manage the cost of capital maturity of liabilities is longer than the life expectancy of assets, then there will be plenty of assets around to pay off debts. However, these surplus assets may not earn enough to increasemaking financial decision and manage the cost of capital market value of the firm.

Evaluating the project to make the right decision mismatching of liabilities with assets can occur if financing is not available. For example, suppose long-term financing is not available. Short-term sources of financing may have to be used. Mismatching can also be intentional. For example, suppose you expect long-term interest rates to fall. You may want to finance assets with short-term maturities since you can refinance in a few years at much lower rates.

Inflation

Another factor to consider inmaking financial decision and manage the cost of capital financing decision is inflation. By using debt financing during periods of high inflation, you will repay the debt with dollars that are worth less. As expectations of inflation increase, making financial decision and manage the cost of capital rate of borrowing will increase since creditors must be compensated for a loss in value. Since inflation is a major driving force behind interest rates, making financial decision and manage the cost of capital financing decision should be cognizant of inflationary trends.

Floatation Cost

Equity sources of capital will cost more than debt sources of capital. One reason is due to higher risk to investors. Whenever investors incur more risk, they demand higher rates of return; i.e. risk return tradeoff. Additionally, making financial decision and manage the cost of capital actual out-of-pocket cost associated with equity financing is higher than debt financing. These costs are referred to as floatation costs. Floatation costs include all costs of issuing making financial decision and manage the cost of capital securities, such as banker's fees, legal fees, filing costs, etc.

Marginal Cost of Capital

A basic consideration withinmaking financial decision and manage the cost of capital financing decision is how much money do we need to raise? If we assume that all projects have the same average level of risk, then we can establish an optimal capital budget by plottingmaking financial decision and manage the cost of capital Marginal Cost of Capital. Evaluating the project to make the right decision relationship between cost of capital and required financing is referred to asmaking financial decision and manage the cost of capital Marginal Cost of Capital. Evaluating the project to make the right decision Marginal Cost of Capital Rate ismaking financial decision and manage the cost of capital discount rate used for capital budgeting analysis. Marginal Cost of Capital is calculated as follows:

1. Determinemaking financial decision and manage the cost of capital cost and percentage of financing needed for each source of capital - debt, stock, retained earnings.

2. Calculate breaking points wheremaking financial decision and manage the cost of capital weighted average cost of capital begins to increase under different financing plans. Evaluating the project to make the right decisionbreak point can be calculated as: Maximum Amount of Lowest Source of Capital / Percent of Financing Provided by this Specific Source of Capital.

3. Calculate the weighted average cost of capital overmaking financial decision and manage the cost of capital range of financing between the break points.

4. A graph can be used to showmaking financial decision and manage the cost of capital range of cost of capital in relation to total financing. If a project's internal rate of return is greater than the marginal cost of capital, thenmaking financial decision and manage the cost of capital project should be accepted.





At $ 2.8 million, making financial decision and manage the cost of capital cost of capital jumps from 9.8% to 12.3%. If we compare this graph to our proposed projects, we will select projects A and B since they have an internal rate of return greater thanmaking financial decision and manage the cost of capital marginal cost of capital (9.8% up to $ 2.8 million and 12.3% above $ 2.8 million). Evaluating the project to make the right decisiontotal investment amount of projects A and B is $ 3.5 million ($ 1.8 for project A + $ 1.7 for project B). Therefore, making financial decision and manage the cost of capital optimal capital budget for Bishop Corporation is $ 3.5 million.

EBIT / EPS Comparison

Inmaking financial decision and manage the cost of capital previous example, we selected a 50 / 50 mix for financing capital projects. One of the objectives of capital management is to findmaking financial decision and manage the cost of capital right mix of capital. A comparison of Earnings Before Interest Taxes (EBIT) with Earnings per Share (EPS) under different financing plans can help determine which type of financing is most advantageous - debt financing or equity financing. Since debt has little effect on EBIT, we start our analysis with EBIT. We simply want to calculate what EPS will be under each financing plan. Bothmaking financial decision and manage the cost of capital debt and stock financing plans are plotted on a graph. Depending upon what we expect EBIT to be, the graph can tell us which financing plan will give usmaking financial decision and manage the cost of capital highest EPS. Evaluating the project to make the right decisionfollowing graph plots EBIT and EPS under debt and stock financing:



At a level of $ 2 million EBIT, EPS ismaking financial decision and manage the cost of capital same under either the stock or debt financing plan. If we expect EBIT to be below $ 2 million, then we would favormaking financial decision and manage the cost of capital stock plan since it yields a higher EPS. If we expect EBIT to be above $ 2 million, then debt would be preferred over stock after consideringmaking financial decision and manage the cost of capital increased risk.



In the above example, it is quite clear that Atco can benefit frommaking financial decision and manage the cost of capital use of more debt. However, suppose Atco expects EBIT to fall dramatically overmaking financial decision and manage the cost of capital next few years. Atco should graphmaking financial decision and manage the cost of capital two financing plans under different levels of EBIT. In order to prepare a graph, we need to determine three points:

1. Evaluating the project to make the right decisionminimum level of EBIT needed to cover fixed financing charges (debt and preferred stock) under 100% Stock Plan.

2. Evaluating the project to make the right decisionminimum level of EBIT needed to cover fixed financing charges (debt and preferred stock) under 100% Bond Plan.

3. Evaluating the project to make the right decisionIndifference Point where EPS ismaking financial decision and manage the cost of capital same under the 100% Stock Plan and the 100% Bond Plan. Evaluating the project to make the right decisionfollowing formula can be used to calculatemaking financial decision and manage the cost of capital Indifference Point:

EPS = ((EBIT - I) (1 - TR) - PD) / number of shares outstanding
EPS: Earnings per Share EBIT: Earnings Before Interest Taxes TR: Tax Rate
PD: Preferred Dividends



Now that we have calculated all three points per Example 13, we can summarize our analysis onmaking financial decision and manage the cost of capital following graph:



At an EBIT of $ 760,000, we have an EPS of $ 1.10.

Assessing Risk

Once returns have been analyzed under different financing plans with EBIT / EPS comparisons, it is necessary to assess risk. Coverage ratios are commonly used to assess the risk associated with different financing plans. Coverage ratios showmaking financial decision and manage the cost of capital additional risk associated with higher levels of debt financing. Examples of coverage ratios include:
  • Debt to Total Assets Ratio = Total Long-term Liabilities / Total Assets
  • Times Interest Earned Ratio = EBIT / Interest Expense
  • Times Burden Earned Ratio = EBIT / Interest Expense + (Principal Repayment / (1 - TR))

Targeted Debt Levels

One approach to establishingmaking financial decision and manage the cost of capital right mix of capital is to follow a targeted debt level. Since some level of debt is desirable for maintaining higher returns, many managers will establish a target debt level for their capital structures (such as 40% of capital should be debt). Therefore, financing decisions should sometimes take into account a targeted set of coverage ratios. One of the principal concerns with using more debt ismaking financial decision and manage the cost of capital ability to cover the additional fixed charges. As we just discussed inmaking financial decision and manage the cost of capital previous segment, coverage ratios are used to monitor debt levels.

Another concern withmaking financial decision and manage the cost of capital use of more debt is financial flexibility. As we increase debt, we risk the possibility of closing off this source of financing in the future. If we expect more and more financing inmaking financial decision and manage the cost of capital future, then we need to make sure we have the flexibility to tap into debt financing overmaking financial decision and manage the cost of capital long-term.

The Overall Process

Evaluating the project to make the right decision basic process for making financing decisions often boils down to three steps:

1. Measuring making financial decision and manage the cost of capital returns under different financing plans. A comparison of EBIT / EPS under different financing plans can help. You also need to understand how much earnings will grow inmaking financial decision and manage the cost of capital future. If you expect EBIT to decline in the future, then you will favor stock over debt. If you expect strong growth in earnings, then you havemaking financial decision and manage the cost of capital ability to service higher debt loads and thus you will lean towards debt over equity.

2. Assessingmaking financial decision and manage the cost of capital risk of each plan. Evaluating the project to make the right decisionobjective is to grow the business with some use of leverage and avoid excessive loads of equity. Coverage ratios (as previously discussed) are widely used to monitor risk. Under ideal circumstances, you want to growmaking financial decision and manage the cost of capital business according to a desired growth rate (G). A desired growth rate can be calculated as follows: G = P x R x A x T where P is Profit Margin, R is Retention Ratio, A is Asset Turnover, and T is Financial Leverage.

If the actual growth rate exceedsmaking financial decision and manage the cost of capital desired growth rate, then you need to make sure you don't borrow too heavily since you need to maintain borrowing capacity. Higher debt loads for fast growing companies can hold back values. If there is low growth, financing with debt may be preferred since steady cash flows are available to service debt financing. Slow growing companies need to aggressively pursue investment opportunities for increased growth.

3. Recognizingmaking financial decision and manage the cost of capital need for financial flexibility. Selecting a financing plan that allows for future flexibility can be critical to future success. You must be able to make competitive investments inmaking financial decision and manage the cost of capital future to maintain or improve market share.

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