LONG TERM

FINANCING
MORA · GACUTAN · CORDON ·
NACINO · ESTEBAN · BAYLON
MARKET ANALYSIS:

- Employment = moderate
- Stronger balance sheet - Country debt is
approximately 40%
- Inflation is low
- Foreign Direct Investment 10Bn (2018)
and dropped 40% this year.
- Economy is resilient 5.5% growth. 5.8% at
the year end projection.
USD VS PESO
Long-Term
Financing
Debt
 Advantages of Debt
Financing
 The lender is not entitled to interfere borrower’s business decisions.
The relationship between two parties is terminated once the debt is
settled;

 Lender can’t claim on business’s future earnings;

 Business may plan for repayments as they are typically fixed and
known;

 Interest payments are tax deductible which smooth the effect of

interest burden;
 Finally ,it’s more convenient from legal and regulative perspective;

9
Disadvantages of Debt Financing
 Debt amount must be repaid in some future
time;
 Payments never take account company’s
business cycle or economy’s future conditions as
a result company may confront with insolvency
risk in rough financial periods;
 Interest charge is a cash expense and to
cover it some money must be withdrawn from
business which limits company’s growth
opportunities;
 The company is typically required pledge some
assets as collateral or sometimes lenders seek for owner’s personal
guarantee;
10
 Reasons for Seeking Debt
Finance
 Sometimes businesses may need
e
long-term funds, but may not wish to issu
equity capital;

a.shareholders will be unwilling to

contribute additional capital;
b.company may not wish to involve
outside shareholder;
c.particularly if the company has little or no
existing debt finance it may be easily
available;
11
Long-Term Debt
Instruments

12
Bonds and Their Features Basic
Terminology

A long-term debt instrument with a final maturity
generally being 10 years or more;
a. par value- amount to be paid the lender at the end of
maturity(it’s usually $1000);
b. coupon rate- a stated rate of interest on a
bond.Calculated by dividing coupon payment by par
value;
c. maturity-bond always have a stated maturity when the
company is obligated to pay bondholder the par value;.
d. current yield-the amount of return an investor will
realize on a bond.Calculated by dividing amount of
interest by market value; 9
 The Risks of Bond Interest Rate
Risk
 Market price of bonds moves inversely to
prevailing interest rates in market;

 When market interest rates rise bond’s

value will decrease;

 When market interest rates decrease then

an increase in bond’s price will be inevitable;

 This situation is relevant only for

bondholders who are going to keep
instrument until maturity;

14
 The Risks of Bond
 Reinvestment Risk- danger that bond investors face is
reinvestment risk, which is the risk of having to reinvest
proceeds at a lower rate than the funds were previously
earning;
 Default Risk-possibility of default must be considered;

Inflation Risk-purchasing power will decrease so the real


return rate:
 Liquidity Risk-repayments are never fully guaranteed;

15
 Types of Bonds
 Zero-coupon bond is bond that makes no periodic interest
payments and are sold at a deep discount from face value;

 Floating-rate notes have a variable coupon,equal to a money

market reference rate, like LIBOR or federal funds rate, plus a
quoted spread.;

• Junk bond-Companies that issue junk bonds typically have less-

than-stellar credit ratings, and investors demand these higher yields
as compensation for the risk of investing in them;

16
 Types of Bonds(cont.)
 Convertible bonds include provision

■ of obtaining debt issuing company’s stock in future. Typically lower interest rates are
inherent to convertible bonds;

• Eurobond-is a bond issued in a currency other than the currency of the

country or market in which it is issued;

17
 Debentures

Debenture – A long-term, unsecured

debt instrument.

 Investors look to the earning power of the firm as their

primary security;
 Investors receive some protection by the restrictions
imposed in the bond indenture, particularly any
negative-pledge clause;
 A negative-pledge clause precludes the corporation
from pledging any of its assets (not already pledged) to
other creditors;
18
 Preferred Stock
■ Represents equity of a corporation, but is different from common stock
because it has preference over common in the payments of dividends
and in the assets of the corporation in the event of bankruptcy.
■ Preferred shares have a stated liquidating value, usually $100 per share.
■ Preferred dividends are either cumulative or noncumulative.
What is Common Stock?

■ Common stock is a type of equity share issued by a corporation or entity. The buyers
of common stock are referred to as shareholders.
Ownership Equity
■ Common stocks are fractional shares or a percentage equity ownership of an entity.
Shares represent a proportional stake in the company’s net worth, income, cash
flow, dividend, etc. Shareholder privileges usually include voting rights on issues that
require shareholder approval and electing the directors of the entity.

Why Issue Common Stock?

■ When a company needs to raise capital for starting or growing their business they
can borrow the money or sell investors’ (shareholders) shares or ownership in the
company.
Advantages of Investing in Common
Stocks
■ Investment With Limited Liability
■ Last to Get Paid
■ High Earning Potential
Disadvantages of Investing in Common
Stocks
■ Lack of Control
A disadvantage of common stocks is that it can be difficult or impossible to exercise
control over your investment.
The Case
■ Fultex is in a very competitive industry. Its main strategy is the reputation in quality
and styling. Since the company strategy is to expand into a wider range of the
consumer market, Fultex needs to get an external fund of $81 million to develop a
new R+D plant that will increase its market share. Fultex’s board of directors has
approved this additional fund needed already. However, there is a conflict between a
board member, the CFO, and a major stockholder. The board member does not want
Fultex to incur more debt, while the major shareholder does not want to lose his
control, and the CFO believes that Fultex has capability to borrow.

The problem in this situation is ‘How should Fultex finance its 81 million expansion
and be in the best interest of all?’
Point of view
■ 1. Issue 700,000 common stock at $ per share.
2. Issue $81 million 10% 15-year callable bond.
3. Issue ,700,000 preferred stock at $ per share
4. Combination of a 50/50 mix of stock and bond.
5. Borrow $81 million from investment bank.
6. Ask Barro to commit $5 million and issue $56 million10% 15-year
callable bond.
7. Borrow $15 million from investment bank to stay alert for possible
innovation.
8. Educate Barro about the economic situation
9. Educate Harrof about using the industry average.
10. Defer the expansion until we know the economic situation.
11. Lease the manufacturing facilities
12. Remain status quo
Areas of consideration
■ R.Craig Harrof, a board member, sent a memo to Elizabeth Bethea, the chief financial
officer of Fultex, explained that Fultex is highly over leveraged based on the comparison
of the firm’s current, quick, debt, D/E, TIE, FCC ratios to the industry average. The
company should not borrow to fund the $81 million expansion.
Elizabeth Bethea discussed the memo with William Gibbs, a vice president, that she is
far from convinced the firm is over-leveraged and she believed that the firm has capacity
to incur debt because of reasons.
1. We are more profitable than typical firm
2. Our risk is low because we are well diversified
3. We have customer loyalty

■ Anthony Barro, a major stockholder with 6% of the firm stock, prefers that Fultex issues
debt to raise the fund needed because he feels that Fed will do everything to avoid
recession and inflation will finally increase. On the other hand, most economists feel that
Fed is very much concerned with containing inflation and economic downturn is quite
likely. However, Bethea realizes that economic forecasting is an inexact science and
majority opinions can easily be wrong.
Conclusion and recommendations:

■ Fultex must consider the Stock Option since Bonds are also subject to various risks such as call and
prepayment risk, credit risk, reinvestment risk, etc.
■ Price changes in a bond will immediately affect mutual funds that hold these bonds. If the value of the
bonds in a trading portfolio falls, the value of the portfolio also falls.
■ Choosing the Stock option help you raise capital. The advantage of selling equity is that there's no
obligation to repay the investor for the shares sold. If the business fails, the stock becomes worthless, but
the company doesn't have to make the investor whole.
■ Issuing common stock also allows Fultex to bring other qualified businesspeople into the mix. Because
investors own part of the company, they have a vested interest in its success and will likely offer services
and resources to help.
Fultex
Long Term Financing
■ 1. A. Calculate the following break-even sales volumes for Fultex at the present time (year 20e)
assuming CGS is the only variable cost
EBT = 0
𝐹𝐶
𝑆∗ =
𝑉𝐶
1− 𝑆
= 93.5 / 1 – 414.5/560.1
= 359.68

Cash flow from operations; that is NI + Dep. = 0/

𝐹𝐶 − 𝐷𝑒𝑝.
𝑆∗ =
𝑉𝐶
1− 𝑆
= 93.5 – 19 / 1 – 414.5/560.1
= 286.59
■ B. Express your answers as a percentage of Fultex’s sales
EBT = 0 64.22%
CF from Operations 51%
■ C. What do your answers suggest about Fultex’s risk?
According to the fact that the competitor's percentage are higher than Fultex; for the
company to avoid to be pushed out of the market on the succeeding years, is to increase
their earnings. Therefore, in order to be more competitive in the market, Fultex should get a
lower risk compared to competitor's one maybe making altering its production techniques.
■ 2. Calculate Fultex’s current year (20e) debt service coverage and capital service
coverage ratios. The firm’s lease payments total $3,360(000) and dividends equal
$1,100(000). The firm’s chief financial officer estimates that the ratios are 2.4 and 1.9
respectively for the firm’s seven competitors.
𝐸𝐵𝐼𝑇 + 𝐿𝑒𝑎𝑠𝑒
𝐷𝑆𝐶 =
𝐼𝑛𝑡 + 𝐿𝑒𝑎𝑠𝑒 + 𝐷𝐷 (1 − 𝑡)
62.7 + 3.36
= = 𝟐. 𝟔𝟔
10.6 + 3.36 + 10.9
𝐸𝐵𝐼𝑇 + 𝐿𝑒𝑎𝑠𝑒
𝐶𝑆𝐶 =
𝐼𝑛𝑡 + 𝐿𝑒𝑎𝑠𝑒 + (𝐷𝐷 + 𝐷𝑖𝑣. )/ (1 − 𝑡)
62.7 + 3.36
𝐶𝑆𝐶 = = 𝟐. 𝟓𝟒
10.9 + 1.1
10.6 + 3.36 + 1−𝑡
■ 3. A. Calculate Fultex’s current year (20e) DOL. The competitor’s average is 3.0
𝐹𝑂𝐶
𝐷𝑂𝐿 = 1 +
𝐸𝐵𝐼𝑇
82.9
= 1+ 62.7
= 𝟐. 𝟑𝟐
■ B. Calculate its DFI (Degree of Financial Leverage). The competitor’s average is 1.1
𝐼𝑁𝑇
𝐷𝐹𝐿 = 1 +
𝐸𝐵𝐼𝑇
10.6
= 1+ 52.1
= 𝟏. 𝟐𝟎
■ C. Calculate its DTL (Degree of Total Leverage). The competitor’s average is 3.3
𝐷𝑇𝐿 = 𝐷𝑂𝐿 𝑥 𝐷𝐹𝐿
= 2.32 x 1.20 = 2.79
■ D. Interpret your answers.
Fultex’s DOL was below average versus its competitor’s given that every 1% change in units sold will
equal 2.32% change in operating income.Fultex’s DFL was above average versus its competitor’s given
that every for every 1% change in operating income, net income changes by 1.20% due to financial
leverage. Fultex’s DTL was below average versus its competitor’s given that every 1% increase in units
sold is equal to 2.79% increase in net income.
■ E. What do these figures suggest about Fultex’s operating, financial, and overall risk?
Taking into consideration the DTL, it would be better for Fultex Company to reduce Fixed Cost (that
basically is one of the reasons for which the Company should improve its cashflow). Moreover, another
would be to consider EBT, thus we should get lower interest.
4. In light of your previous answers, the information in Exhibit 3, and other information
in the case, evaluate Harrol’s argument that Fultex is overlevered at the present time.
■
5. Complete the table in Exhibit 7. (Assume a dividend of $.10 per share on any new
stock)
Bond option Stock option Combination
Year Interests Dividends Interests Dividends Interests Dividends
1996 8.1 0 0 0.27 4.05 0.135
1997 8.1 0 0 0.27 4.05 0.135
6. A. What is Fultex’s estimated earnings per share (EPS) for succeeding years 20f and
20g if it uses the bond option? The stock option?

Bond option Stock option Combination

Year Interests Dividends Interests Dividends Interests Dividends
1996 8.1 0 0 0.27 4.05 0.135
1997 8.1 0 0 0.27 4.05 0.135
EPS DPS EPS DPS EPS DPS
1996 2.62 0.10 2.46 0.10 2.53 0.10
1997 3.39 0.10 3.08 0.10 3.22 0.10
6. B. What is the year 20f sales indifference point between the bond and the stock
options? Continue to assume the CGS is the only variable cost
Bond Stock Combination
1995 1996 1997 1996 1997 1996 1997
Sales 560.1 640 768 640 768 640 768
COGS 414.5 473.6 568.3 473.6 568.3 473.6 568.3
Operating expenses 63.9 73 87.6 73 87.6 73 87.6
Depreciation 19 27 32 27 32 27 32
EBIT 62.7 66.4 80.1 66.4 80.1 66.4 80.1
Interests 10.6 18 17.3 9.9 9.2 13.95 13.25
EBT 52.1 48.4 62.8 56.5 70.9 52.45 66.85
Net income 31.3 29.04 37.68 33.9 42.54 31.47 40.11
 Bond Stock
1995 1996 1996
Sales 560.1 581.9227 581.92271
COGS 414.5 430.6228 430.62281
Operating expenses 63.9 73 73
Depreciation 19 27 27
EBIT 62.7 51.29991 51.299905
Interests 10.6 18 9.9
EBT 52.1 33.29991 41.399905
Net income 31.3 19.97994 24.839943
Number of shares out. 11.1 11.1 13.8
EPS 1.799995 1.7999959

S* 581.9227
7. Year 20f Estimates Year 20g Estimates
1996 1997
Bond Stock Combination Bond Stock Combination
Debt 0.56 0.36 0.46 0.51 0.33 0.43
D/E 0.91 0.32 0.56 0.72 0.25 0.45
DSC 1.9 2.47 2.2 2.3 3 2.64
CSC 1.8 2.3 2 2.2 3.01 2.5
TIE 3.7 6.7 4.76 4.63 8.7 6
FCC 3.27 5.3 4 4 6.64 5
8. a. Stock options Before Stock Issue Bond option
Number of shares
outstanding 13.8 11.1 Tax rate 40%
Current share price 32 32
All equity financed firm
Market value of equity
(537.1-.40 x 95.5) 498.9
(13.8 x 32) 441.6 355.2
Market value of debt 95.5 95.5 Firm's value (498.9 +
(95.5+81) x .40) 569.5
Firm's value (441.6 +
Value of equity (569.5
95.5) 537.1
– (95.5-81)) 555
Share price
(537.1-95.5 x .40) 498.9 (555/11.1) 50.00
9. sales growth 10%
operating profit
NWC/Sales 23%
Year 0 1 2 3 4
Sales 560.1 560.1 588.1 617.5 648.4
Operating margin 0.125 0.135 0.135 0.14

Operating profit € 559.98 € 587.97 € 617.37 € 648.26

Depreciation 27 31.6 34 36.5

EBIT € 532.98 € 556.37 € 583.37 € 611.76

Interest 9.9 9.2 8.6 8

EBT € 523.08 € 547.17 € 574.77 € 603.76

Taxes (40%) € 209.23 € 218.87 € 229.91 € 241.50

Net income € 313.85 € 328.30 € 344.86 € 362.26

Depreciation 27 31.6 34 36.5

Cash flow from operations € 286.85 € 296.70 € 310.86 € 325.76

-Dividends 1.1 1.1 1.1 1.1
-Debt due 9 9 9 9
-Change in NWC 5.00 6.16 6.47 6.80
-Capital spending 70 55 28 28
10. Based on your previous answers, what option do you recommend?
We recommend that Fultex issue 700,000 common stocks at $1 per share to finance
the $81 million expansion project. This is because their cash outflow is at the minimum
and due to economic forecast, recession is likely to occur and interest rate is expected
to fall, meaning that it is not advisable to borrow now.