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Year III CORPORATE FINANCE

SEM I
 TEMA 2 ENTERPRISE FINANCING POLICY

2.1.The content of the equity, the conditions for creation

and capitalization
2.2.Internal and external funding sources of the entity.
Methods of increasing equity
2.3.Cost of capital and financial structure of the
enterprise. Criteria for its optimization
2.4 Financial leverage, the financial leverage effect. The
risk of insolvency
WHAT IS EQUITY?
 Equity is viewed by the market as an ownership “share” in
the revenue stream of a corporation’s income once all prior
obligations and debts have been satisfied. The “share” price
in an equity definition is the relative value given to the
corporation’s earning potential based on a number of
factors.
 These include general economic conditions, both in the
industry and in the overall economy, earnings projection,
projected corporate growth, corporate stage of
development, and financial ratio analysis. When considering
what is equity and its definition there are three major
variants of equity to look at.
THE THREE BASIC TYPES OF EQUITY

Common Stock
 Common stock represents an ownership in a
corporation. Common stockholders participate in the
earnings stream of the corporation through dividends
paid and capital gains made on a per-share basis.
Owners of common stock are responsible for the
election of the Board of Directors, appointment of
Senior Officers, the selection of an auditor for the
corporate financial statements, dividend policy, and
other matters of corporate governance.
THE THREE BASIC TYPES OF EQUITY

Preferred Shares
 Preferred shares are stock in a company that have a defined dividend, and a prior
claim on income to the common stock holder.
Warrants
 Warrants are a form of option usually added to a corporate bond issue or preferred
stock in order to sweeten the deal. A warrant is a long-dated option that allows the
owner to participate in the capital gains (losses) of a firm without buying the common
stock. In effect, the holder of a warrant has a leveraged play on the corporate
common stock.
 As a form of option, a warrant has an exercise price and an expiry date. The exercise
price is the price at which the holder may convert the warrant into common shares of
the issuer. The expiry date is the last date on which the warrant may be converted
into common shares. Given that a warrant is generally issued to reduce the cost of a
debt issuer, the expiry date is usually more than two years from issuance. This allows
warrants to trade separately from the bond with which they were issued, thereby
providing the investor with a long-dated option on a firm’s common stock.
 Warrant holders have no voting rights until the warrants are converted into common
shares. If the warrants provide for conversion into preferred shares, it is unlikely the
holder will gain any influence into corporate governance upon conversion.
SHAREHOLDERS' EQUITY

 (or business net worth) shows how much the owners of a

company have invested in the business—either by investing
money in it or by retaining earnings over time. On the
balance sheet, shareholders' equity is broken down into
three categories: common shares, preferred shares and
retained earnings.
THE SHAREHOLDERS’ EQUITY FORMULA

 Shareholders’ Equity = Total Assets – Total Liabilities

In this formula, the equity of the shareholders is the difference
between the total assets and the total liabilities. For example, if a
company has $80,000 in total assets and $40,000 in liabilities, the
shareholders’ equity is $40,000. This is the business’ net worth.
 Shareholders’ Equity = Share Capital + Retained Earnings –
Treasury Stock
This formula is sometimes known as the investor’s equation. It takes
the retained earnings of the business and the share capital and
deducts any treasury shares. The retained earnings are the earnings
of the business built up after dividends have been paid to
shareholders. The figure can be found in the shareholders’ equity
part of the balance sheet. Treasury stocks are shares in the business
that have been repurchased to potentially be sold on to investors.
SHAREHOLDERS EQUITY

 refers to the residual claims shareholders of a company can

make after all liabilities have been settled.
 Shareholders equity is realized when the total liabilities
of a company are deducted from its assets.
 Shareholders equity plays an important role when
evaluating the financial health of a company but it cannot
be used as a definitive indication of the company's health.
 The amount invested by investors and the returns a
company make can be measured through shareholders
equity.
WHAT IS STOCKHOLDERS' EQUITY?

 When you take all of the company's assets and subtract the
liabilities, what remains is the equity. For a company with
stock shares, the equity is owned by the stockholders. The
statement of equity is simply the part of a balance sheet or
ledger that clearly calculates and explains the stockholders'
(or shareholders') equity.
Who uses a statement of stockholder equity?
 The statement of stockholder equity is used by companies
of all types and sizes, ranging from small businesses with
just a handful of employees to large, publicly traded
enterprises. For companies that aren't public, the statement
of stockholder equity is often considered the owner's equity.
EXAMPLE
 If Company XYZ has a total assets worth $15.5 million in
2018 and the liabilities accrued for that same fiscal year is
$9.4 million. The shareholders equity will be calculated by
deducting the company's liabilities from its assets for that
fiscal year. Hence, Shareholders' equity = $15.5 - $9.4 =
$6.1 million.
 There is a distinction between equity and shareholders
equity.
 Equity refers to the value of a company that can be
attributed to the owners of the company.
 Shareholders equity refers to the residual claims of
corporation owners of a company after its debts have been
paid. That is, the amount left for the shareholders of a
company after all liabilities have been deducted from a
company's assets.
The surest way to increase shareholders’ value is increasing
profits. How?
 Increase sales;
 All-inclusive hourly cost rates for estimating and costing;
 Cost selling price discipline;
 A target selling price;
 Improve value-added; and
 Decrease costs.
This means that management has to find ways to spend less
money. It’s a strategy of increasing shareholders’ value
without an offset caused by increased debt.
EQUITY MANAGEMENT
 is the process of creating and managing owners in your company.
This may sound simple, but it involves everything from tracking and
reporting changes in ownership to updating documents,
communicating with stakeholders, consulting your board of
directors, and staying compliant.
 Equity management encompasses everyone’s experience—from
equity admins and outside investors to employee stakeholders and
board members. Let’s take a look at the process for each party
involved:
 WHAT ARE THE MAJOR SOURCES OF
FINANCING?
• The three major sources of corporate financing are retained
earnings, debt capital, and equity capital.
• Retained earnings refer to any net income remaining after a
company pays off any expenses and obligations.
• Debt capital is funding that a company raises by borrowing
money from lenders through loans or corporate bond
offerings.
• Equity capital is cash that a public company raises or earns
by issuing new shares to shareholders on the market. This
could be done by selling common or preferred stock.
CAPITAL STRUCTURE
• Capital structure can be a mixture of a company's long-term
debt, short-term debt, common stock, and preferred stock.
• A company's proportion of short-term debt versus long-term
debt is considered when analyzing its capital structure.
THE OPTIMAL CAPITAL STRUCTURE
• The optimal capital structure is estimated by calculating the mix of debt and
equity that minimizes the weighted average cost of capital (WACC) of a
company while maximizing its market value.
• The lower the cost of capital, the greater the present value of the firm's future
cash flows, discounted by the WACC.
 FINANCIAL LEVERAGE
is the borrowing of money to acquire a particular asset that promises a higher return than the
interest on the loan that must be repaid. Thus, financial leverage is an investment strategy that
helps companies grow and expand
Financial leverage can be calculated in different ways - depending on what you are interested in. A
ratio to a certain reference value is always formed.
Financial leverage ratio: Debt-to-equity
The debt-to-equity ratio is the ratio of total debt to total equity: D/E ratio = Total debt / Total equity
Total debt consists of the following Total debt = Short-term debt + long-term debt
Short-term debt is debt with a maturity of one year or less; long-term debt has a longer maturity.
The debt-to-equity ratio indicates how high the shares of debt and equity of the company are. If the
company has more debt than equity, the D/E ratio is greater than 0. If the company has more
equity than debt, the ratio is less than 0.
Debt-to-assets ratio
If you put the debt in relation to the total assets that were acquired with the borrowed capital, you
get the debt-to-assets ratio:
D/A ratio = Total debt / total assets
If the D/A ratio is very high, it means that the company has taken on a lot of debt to invest in assets.
Financial leverage: Example
A company expands and opens another location. For this it must Invest
£1,000,000 in land, property and equipment for the new site. As it does not
have enough equity, it takes out a bank loan of £800,000 at an interest rate
of 5%. It therefore has £840,000 of debt to repay in the future.
His total equity after the investment is still £1,500,000. There are no other loans
and the amount of total company assets after the investment is £2,500,000.
Now we calculate the financial leverage: Debts-to-equity ratio = £840,000 /
£1,500,000 = 0.56 = 56%
Debts-to-assets ratio = £840,000 / 2,500,000 = 0.336 = 33.6%
The debts-to-equity ratio indicates that 56% of the capital is borrowed. The
debts-to- assets ratio indicates that 33.6% of the company's total assets are
financed with debt.
Sourse:https://agicap.com/en/article/financial-leverage/
WHAT IS INSOLVENCY RISK?
• Insolvency risk is the real possibility that a company may be unable to
meet its payment obligations in a defined period of time – generally in a
one-year horizon. It is also known as bankruptcy risk
• Bankruptcy risk, or insolvency risk, is the likelihood that a company will be unable
to meet its debt obligations. It is the probability of a firm becoming insolvent due
to its inability to service its debt. Many investors consider a firm's bankruptcy risk
before making equity or bond investment decisions.
• Firms with a high risk of bankruptcy may find it difficult to raise capital from
investors or creditors.
• Credit agencies such as Moody's and Standard & Poor's attempt to assess
bankruptcy risk by producing bond ratings as well as rating the issuers.
Sourse:
https://www.investopedia.com/terms/b/bankruptcyrisk.asp
REFERENCES
https://agicap.com/en/article/financial-leverage/
https://www.investopedia.com/ask/answers/06/highleverage.as
p
https://www.basic-concept.com/c/basics-of-corporate-finance
https://www.investopedia.com/terms/b/bankruptcyrisk.asp