Lecture No. 49
Chapter 15
Contemporary Engineering Economics
Copyright © 2010
Contemporary Engineering Economics, 5th edition, © 2010
Chapter
Opening Story
 Disney’s Shanghai Park Plan
Advances

$3.59B investment in
building a theme park
in mainland China
 Disney needs to find a
way to finance this
large scale project, if
the project gets going.
 Because of the size of
financing involved, the
firm financing method
will affect the firm’s
capital structure, the
cost of capital , and
financial risk.
Contemporary Engineering Economics, 5th edition, © 2010
Methods of Financing
 Equity Financing – Capital is
coming from either retained
earnings or funds raised from
an issuance of stock.
 Debt Financing – Money raised
through loans or by an
issuance of bonds.
 Capital Structure – Well
managed firms establish a
target capital structure and
strive to maintain the debt
ratio.
Contemporary Engineering Economics, 5th edition, © 2010
Capital Structure
Debt
Equity
Equity Financing
 Flotation (discount)
Costs: the expenses
associated with issuing
new securities
 Types of Equity Financing:
 Retained earnings
 Common stock
 Preferred stock
Contemporary Engineering Economics, 5th edition, © 2010
Retained earnings
Preferred stock
Common stock
Example 15.1 Equity Financing by Issuing Common Stock
Scientific Sports, Inc. (SSI)
needs to finance $10 million to
develop and produce a new
metal golf driver.
Share price for the new stock
offering = $28
Flotation cost = 6%of the
issue price
Question: How many shares
must SSI sell to net $10 million?
(0.06)($28)(X) = 1.68X
Sales proceeds – flotation cost = Net proceeds
28X – 1.68X = $10,000,000
26.32X = $10,000,000
X = 379,940 shares.
1.68(379,940) = $638,300
Contemporary Engineering Economics, 5th edition, © 2010
Debt Financing
 Bond Financing:
 May incur flotation cost
 No partial payment of principal
 Only interest is paid each year
(or semi-annually)
 The principal (face value) is paid
in a lump sum when the bond
matures
 Term Loan:
 May involve an equal
repayment arrangement.
 May incur origination fee
 Terms negotiated directly
between the borrowing
company and a financial
institution
Contemporary Engineering Economics, 5th edition, © 2010
Bond
Term Loan
Example 15.2 Debt Financing by Issuing Bonds
Scientific Sports, Inc.
(SSI) needs to finance
$10 million by issuing a
mortgage bond.
 Face value = $1,000
 Market price = $985
 Coupon rate = 12%
interest payable annually
Floatation cost = 1.8%
of the issue price
Question: (a) Number
of bonds to be sold to net
$10 million? (b) the total
annual interest payment

(a) To net $10 million, SSI would have to sell
$10,000,000/(1- 0.018) = $10,183,300
worth of bonds and pay $183,300 in
flotation costs. Since the $1,000 bond
would be sold at $985, a 1.5%
discount, the total number of bonds to
be sold would be
$10,183,300/($985) = 10,339.

(b) For the bond financing , the annual interest is
equal to
$10,338,380 (0.12) = $1,240,606
Only the interest is paid each period,
and thus the principal amount owed
remains unchanged.
Contemporary Engineering Economics, 5th edition, © 2010
Capital Structure (Debt Ratio)
 Definition: The means by which a firm is financed.
 Mixed Financing: Capital is raised by borrowing from
financial institutions and by issuing stocks and/or using
retained earnings.
 Target Capital Structure: Set a target debt ratio by
considering both business risk and expected future
earnings.
Contemporary Engineering Economics, 5th edition, © 2010
Example 15.3 Project Financing Based on an Optimal
Capital Structure
 SSI’s capital structure = 0.50
 Raise $5M by issuing common
stock and $5M by issuing bonds at
12% interest.
 Floatation cost:
Stock: 8.1%
 Bond: 3.2%
 Project Description:
 Life: 5 years
 Building: $3M
 Equipment: $6M
 Land: $1M
 Cash dividend: $2 per share
 Unit production cost: $50.31
 Unit price: $250
 Annual O&M cost: $600,000
 Annual demand: 20,000 units
 Working capital: $500,000
 Tax rate: 40%
Contemporary Engineering Economics, 5th edition, © 2010