Raising Additional Funds

1
Raising Additional Funds

• Once firm establishes optimal capital structure,
  it should try to raise new funds in those optimal
  proportions
• Easy to do in theory
• Harder to do in practice

2
Marginal Cost of Capital

• Because some sources of financing eventually run
  out, the cost (Ka) of the last raised may be
  higher than the cost of the first raised
• MCC Ka of last dollar raised in optimal
  proportions

3
MCC Example

• Optimal Capital Structure identified as 30 debt,
  10 P/S, 60 common equity.
• Firm needs to raise 150,000,000

4
Sources Available to Firm

• Debt Ki 6 for borrowing 36,000,000 or less
  Ki 8 for borrowing gt 36,000,000
• P/S Kp 12 (no limit)
• Common Equity Expected EAT 100,000,000,
  Dividend Payout Ratio 55, Kc 15, Knc 16
  (no limit)

5
Finding Breakpoints

• In determining MCC, must first see how much money
  can be raised in total (from all sources) before
  running out of one source and switching to a more
  expensive source
• R/E Breakpoint (R/E Available)/Wc
• Shows how much can be raised in total before
  exhausting available R/E

6
Example of R/E Breakpoint

• R/E Available .45(100,000,000) 45,000,000
• If in keeping op cap structure, 60 of new funds
  must come from common equity, the most we can
  raise in total using only R/E as common equity
  source .60x 45,000,000
• x 45,000,000/.60 75,000,000
• 75,000,000 1st Breakpoint

7
Debt Breakpoint

• Amount of debt that can be raised at a certain
  interest rate may be limited
• Debt Breakpoint Limit on Debt/Wi
• Shows how much money can be raised in total
  before low-cost debt is exhausted

8
Example of Debt Breakpoint

• Limit on borrowing at 6 36,000,000
• If 30 of total amount raised comes from 6 debt
  .30x 36,000,000
• x 36,000,000/.30 120,000,000
• 120,000,000 2nd Breakpoint

9
Using Breakpoints

• Once you have breakpoints established (for R/E
  and/or for debt), you use them to identify
  different increments of fund raising
• 1st increment is always raised with cheapest
  sources
• Subsequent increments have more expensive sources
  substituted for cheaper sources that are used up

10
Calculating MCC

• Once the increments have been identified using
  breakpoints, you can calculate Ka for each
  increment
• MCC Ka for last dollar raised (in an increment)
• MCC Schedule shows costs of different increments
  in raising a certain amount of money

11
Using Breakpoints from Example to Calculate MCC

• Trying to raise 150,000,000
• 1st 75,000,000 will be raised using 6 debt and
  retained earnings
• MCC for 1st 75,000,000 .30(.06) .10(.12)
  .60(.15) .12
• After raising 75,000,000, R/E run out and we
  substitute new C/S

12

• Can raise up to 120,000,000 using 6 debt
• MCC for money raised gt 75,000,000 but less than
  or equal to 120,000,000 .30(.06) .10 (.12)
  .60(.16) .126
• Run out of 6 debt after raising a total of
  120,000,000

13

• MCC of amounts raised over 120,000,000
  .30(.08) .10(.12) .60(.16) .132
• Summary 1st 75,000,000 raised cost firm 12
  next 45,000,000 raised cost 12.6 final
  30,000,000 raised cost 13.2

14
MCC Schedule

• Graph showing MCC as different amounts of capital
  are raised
• X axis raised
• Y axis MCC (Ka)
• Ends up looking like series of rising steps