Methods of Financing
Lecture No. 60
Chapter 15
Contemporary Engineering Economics
Copyright © 2006
Contemporary Engineering Economics, 4th
edition, © 2007
Chapter Opening Story – Hotels Go to
the Mattresses
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Marriott International
plans to launch a major
initiative to replace
nearly every bed in
seven of its chains.
Total estimated cost:
$190 million
Issue: How to find a
way to finance this
large-scale project?
Contemporary Engineering Economics, 4th
edition, © 2007
Methods of Financing
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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, 4th
edition, © 2007
Capital Structure
Debt
Equity
Equity Financing
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Flotation (discount)
Costs: the expenses
associated with issuing
new securities
Types of Equity
Financing:



Retained earnings
Common stock
Preferred stock
Contemporary Engineering Economics, 4th
edition, © 2007
Retained earnings
+
Preferred stock
+
Common stock
Example 15.1 Issuing Common Stock
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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?
Contemporary Engineering Economics, 4th
edition, © 2007
Flotation Cost
• Issue: Raise net $10 million
• Stock price: $28 per share
• Flotation cost: 6% of the stock price, or $1.68 per share
• Question: How many shares to issue?
(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, 4th
edition, © 2007
Debt Financing
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Bond Financing:
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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:



Bond Financing
Involve an equal repayment
arrangement.
May incur origination fee
Terms negotiated directly between the
borrowing company and a financial
institution
Contemporary Engineering Economics, 4th
edition, © 2007
Term Loans
Example 15.2 Debt Financing

(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) = 10,338.38.

(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, 4th
edition, © 2007
Capital Structure (Debt Ratio)
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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, 4th
edition, © 2007