Republic of the Philippines

CAVITE STATE UNIVERSITY

Imus City Campus
Cavite Civic Center, Palico IV, Imus City Cavite
(046) 471-6607 / (046) 471-6770 / (046) 686-2349
www.cvsu.edu.ph

SOURCES OF CAPITAL:
EQUITY AND DEBT FINANCING
(BMGT24: BASIC FINANCE)

SUBMITTED BY:
Bedeo,Pamela Ruth
Cagula, Marinelle
Orcullo, Darillyn Jhane
Pagalilauan, Edsil Lauren
Rabo, Sarah
BSBM-2D

SUBMITTED TO:
Ma’am Nora Capistrano
Sources of Capital

The total capital of a business consists of:

EQUITY (capital stock financing) & DEBT FINANCING (borrowed capital / borrowings)

EQUITY is the financial resources provided by owners of the business.

To get the equity: (assets - liabilities = equity)
- For single proprietorship, the owner’s equity.
SOLE PROPRIETORSHIP
Owner’s equity:
Alpha, Capital, January 1, 2020 Php 100,000
Add: Net Income, 2019 50,000
Php 150,000
Less: Drawings: ( 20,000)
Alpha, Capital, December 2020 Php 130,000
- For partnership, the partner’s equity.
PARTNERSHIP
Partner’s equity:
Alpha Php 150,000
Beta 250,000
Charlie 100,000
Php 500,000
- For corporation, the stockholder’s equity.
CORPORATION
Stockholder’s equity:
Contributed Capital
12% Preferred, Non-participating
Per value Php 100
Issued 22,000 shares Php 2,200,000
Common stock
Authorized 50,000 shares,
Per value Php 50.00
Issued 40,000 shares 2,000,000
Total Contributed Capital Php 4,200,000

Retained earnings
Appropriated for:
Plant expansion Php 1,000,000
Un-appropriated 3,000,000 4,000,000
Total Stockholder’s Equity Php 8,200,000
Advantages of Equity as a source of capital by issuing ordinary shares
1. A company is not required to pay dividends to ordinary shareholders.
2. Ordinary shares do not have any maturity date.
3. The higher the proportion of equity in a company’s capital structure, the lower will be the risk
that creditors will suffer losses as a result of the borrower experiencing financial difficulty.
 Disadvantages of Equity
1. If a company issues more ordinary shares to raise capital, existing shareholders will have to
either outlay additional cash or suffer some dilution of their ownership and control of the
company.
2. Dividends paid out of after-tax profit are generally subject to further taxation in the hands of
investors.
CAPITAL STOCK
 Financing supplies permanent funds to the business through EQUITY or ownership channels
in the capital markets.
 It is concerned with demand and supply in the stock markets.
 The stock markets report what investors are willing to pay to become owners in a business.
FORMS OF CAPITAL STOCK
1. AUTHORIZED CAPITAL STOCK
the maximum number of shares that the business owners are allowed to issue.
2. ISSUED STOCK
 is the amount of authorized stock subscribed to and paid for in cash, property or services.
3. REACQUIRED STOCK
 can be reacquired in two ways:
a. by gift from stockholders;
b. by buying back some of the company’s issued stock
4. OUTSTANDING STOCK
 is the portion of issued stock not reacquired
The contractual provisions of the stock forms for the following reasons:
 Stock is authorized and issued on the basis of shares;
 Stock is reacquired by the business in terms of shares;
 Stock is voted on the basis of shares;
 Profits are calculated on the basis of shares;
 Dividends are declared on the basis of shares;
 Stock purchase rights are distributed on the basis of outstanding shares;
 Assets are distributed in liquidation on the basis of shares.
CLASSES OF STOCK
1. COMMON SHARES
Units of ownership registered in the names of the proprietors.
Rights and limitations are:
a. Right to vote or elect the board of directors of a corporation.
b. Right to share in profits and dividends as residual claimants after preferred shares; and
when management decides to pay dividends.
c. Pre-emptive common law right on issuance of common stock before selling to public.
d. Right to assets in liquidation, where right is pro-rata based, during voluntary or forced
liquidation.
2. PREFERRED SHARES
 Issuance is indicated in the articles of incorporation.
Rights and limitations are:
a. No right to vote.
b. Right to share in profits and dividends.
DEBT FINANCING. Businesses can borrow from many sources, and the range of sources to choose
is generally related to the size of business.

Small business will usually have a relationship with one bank and will rely on that bank for most or
perhaps all of its debt finance.
Large companies are not restricted to borrowing from financial intermediaries and also issue
securities such as bills of exchange.

Current Debt (short-term) Non-current Debt (long-term)

debt due to repayment within a period of debt with maturity term of more than twelve
twelve months. months.
Examples of current debt: Examples of non-current debt:
• Short-term bank loans • Bonds
• Accounts payable • Individual notes payable
• Wages • Convertible bonds
• Lease payments • Lease obligations or contracts
• Income taxes payable • Pension or postretirement benefits
• Contingent obligations
Secured Debt Unsecured Debt
the creditor has claims against the borrower the lender has a claim against borrower but
and against assets of the borrower. no additional claim to any particular property
Some common types of owned by the borrower.
Secured debt includes: Some common types of
• Mortgages Unsecured debt includes:
• Car loan • Most credit cards
• Secured credit cards • Most personal loans
• Medical debts
Marketable Debt
 takes the form of securities such as notes, bonds or debentures which are issued to investors and
can be traded in secondary market –that is, the ownership of marketable debt is transferable.
Examples of marketable debt:
These are financial instruments that can be easily converted to cash such as government
bonds, common stock or certificates of deposit.
Non-marketable Debt
 takes the form of loans arranged privately between two parties where the lender is usually a bank
or other financial intermediary.
Examples of non-marketable debt:
Common examples of nonmarketable securities include U.S. savings bonds, rural electrification
certificates, private shares, state and local government securities, and federal government
series bonds. Nonmarketable securities that are prohibited from being resold, such as U.S. savings
bonds, are required to be held until maturity.
Fixed Interest Rate
 Borrowers can obtain short-term debt by issuing marketable securities such as bills.
 Similarly, most marketable long-term debt securities have it, which does not vary over the life of
security.
Variable (Floating) Rate
 Involved most intercompany loans and short-term bank loans.
 Where applies, the rate will generally consists of a base rate plus a margin that depends on
the risk of the borrower.
 The interest rate will therefore change whenever the base rate (indicator lending rate)
changes.
Capital from creditors gives rise to a liability, which can be in any of the following forms:
• Buying property, equipment, raw materials and availing of services on credit
• Loan from financial intermediaries
• Issuance of commercial papers and bonds
• Advances from affiliate companies and officers
• Accounts and notes receivable discounting
Financial leverage
the use of borrowed capital. The company is willing to pay interest and other charges on borrowed
capital with the intention of raising the earnings per share on common stock. The financial
advantage of increasing the capacity to produce and sell, other sources of income, and business
opportunities, and meet decline in economic cycle can be attained in using borrowed capital.
Interest
the cost of borrowed capital. This is deductible for income tax purposes, and the tax benefit is
considered an adjustment to interest expense for determining the cost of borrowed capital.

To illustrate the computation for Interest: Cost of borrowed capital = Interest x (1-tax rate)

Example:
Corporation Ruthy obtained a loan of Php 800,000 for a term of one year from RN Financing
Company at 20% interest. Rate of income tax is 35%.

Cost of borrowed capital = 20% x (1-35%)

= .20 x (.65)
= .13 or 13%

Interest of 20% on Php 800,000 = Php 160,000

Tax benefit @35% of Php 160,000 = (56,000)
Interest expense net of tax benefit = Php 104,000

Percentage (Php 104,000 / 800,000) = 13%

EXTERNAL SHORTTERM FINANCING
 Refers to a rather limited and specialized area in financial decision concerned primarily with
bringing funds into the business.
 The size of the capital of the business acts as a kind of material barrier to the amount of
shortterm financing that a business can do.
 A one-year period can be more convenient to report financial conditions to stockholders and
creditors.
Liquidity
 Liquidity of individual borrowing is measured by the percentage of cash secured on the face
value of the debt.
 Cash, cash equivalents and other assets (liquid assets) that can be easily converted into cash
(liquidated).
Solvency risk factor
 Default on payment of principal and interest.
 Solvency risks increase as the total volume of shortterm financing increases.
Profitability
 Measured in terms of opportunity cost, or what would be foregone for a decision, and financial
expenses such as service charges, interest charges and carrying charges.

MAJOR SOURCES OF FUNDS

1) Trade Credit Market
 Is any place where raw materials or finished inventories may be purchased on credit.
 Supply sources may include manufacturers and distributers from all over the country and other
nations. Important supply factors to consider are:
• Total quantity of credit available; • Repayments terms; and
• Inventory supply services; • External controls
• Financial expenses;
2) Customer Loan Market
 Is any place where cash funds can be negotiated.
 Supply sources are commercial banks, commercial paper companies, commercial finance
companies, etc. In negotiating for loans, financial managers are concerned primarily with the:
• Quantity of cash available; • Repayment terms; and
• Cash and other related financial • Degree of control exercised over
services; borrower
• Expenses for financing;
3) Receivables Sales Market
 The quantity of funds that can be obtain is limited by the quantity of credit sales that are
approved for purchase by the factoring company.
 Since this is not a borrowing, no liability is created on the books of the business when
receivables are sold to a factor. Neither is there maturity or repayment date with which to be
concerned.
 Ownership is not control at all, control exists at the point of credit sales where the factor that
makes decisions about which proposed receivables are acceptable and which are not
acceptable for purchasing.
EQUITY vs. DEBT FINANCING: INVESTED CAPITAL AGAINST BORROWED CAPITAL

Equity or Invested Capital

1) Permanent in the business entity.Reduced by accumulated losses or dissolution.

2) Dividends are paid to investors. Not deductible for income tax purposes.
3) Financial management requires maximizing earnings on invested capital.
4) Owners’ claims, upon dissolution, given after claims of third parties are paid.

Debt Financing or Borrowed Capital

1) Non-permanent. It has its maturity date, with period amortization.

2) Interest and other financing charges are paid to creditors. Deductible for tax purposes, gives
rise to tax benefits.
3) Financial management requires minimizing finance charges on borrowed capital.
4) Creditors’ claims have priority in distribution of asset for liquidation.

It is advisable to use borrowed capital if its rate of return is higher than its cost.

Cost of borrowed capital = Interest x (1-tax rate)

For example:
Delta Corporation is intending to invest Php 1,000,000 for a project with an expected rate of
return at 25%. Loans available at an interest rate of 16% per anmum, and tax rate is 35%.

Cost of borrowed capital = 16% (1-35%)

=.16 x .65
=.104 or 10.4%

The cost of borrowed capital will result in an income of 14.6%

25% (rate of return from the project)

- 10.4% (cost of borrowed capital)
14.6%

If Delta Corporation is currently realizing a net income of Php. 300,000 on invested capital
of Php. 2,000,000 divided into 10,000 shares of capital stock with par of P hp 200,000,
The income from the project would show an increase in owner’s equity of 22.3% (from 15%).
Earnings per share will rise to Php. 44.60 (from Php. 30.00).
Owner’s equity remains at Php. 2,000,000, although an additional capital was made available from
creditors. The borrowed capital gave rise to an increase in rate of return on owner’s equity and the
earnings per share, but an increase in debt to equity ratio from 0:1 to .5:1.

Cash budgeting must provide for obligations to meet on loan maturity for payment of principal and
financing charges. This will not endanger the company’s financial stability.
 Current status Proposed project Total of projections
Php 1,000,000 x 14.6%
Net income Php 300,000 Php 446,000
=Php 146,000
Owner’s equity 2,000,000 - 2,000,000

Rate of return on owner’s equity 15% - 22.3%

Earnings per share
Php 30.00 - Php 44.60
(EPS)
Total liabilities 0 1,000,000 1,000,000

Owner’s equity 2,000,000 - 2,000,000

Debt/ Equity ratio 0:1 - .5:1

LOANS AND AMORTIZATION

 Whenever a creditor extends a loan, some provisions will be made for repayment of the
principal.
 A loan might be repaid on equal installments, or it might be repaid in a single lump sum.
 The way principal and interest shall be paid will depend on the agreement of both parties.

BASIC TYPES OF LOANS

1) Pure Discount Loan
simplest form of loan. The debtor receives money today and repays a single lump sum at some
other time in the future.

A one-year, 10% discount loan,

For example: would require the debtor to repay Php 1.10 on one year for every peso borrowed
today. Suppose a debtor was able to repay Php 25,000 in five years. On the part of the creditor,
who wants an interest rate of 12% on the loan, how much would be the amount to lend now? Or
what should be the amount of loan today, to get Php 25,000 on the fifth year?

This can be a discussion of time value of money, but for this purpose, below is the illustration:
Present Value =Php 25,000 / 1.7623 (refers to the Table on Future Value at the end of t periods)
=Php 14, 186

Treasury bills are pure discount loans. If a T-bill promises to repay Php 10,000 in 12 months, and the
market interest is 7%, how much will the bill sell in the market?
Present Value =Php 10,000 / 1.07
=Php 9,345.79
2) Interest-Only Loan
allows all debtor to pay interest each period and to repay the principal at some point in time. Notice
that if there is just one period, pure discount loans are the same. Most corporate bonds have the
general form of interest-only loan.

For example: With a three year, 10%, interest-only loans of Php 10,000,
The debtor would pay Php 10,000 x .10 = Php 1,000 in interest at the end of the first and second
year. At the end of the third year, the borrower would return the Php 10,000 along with another Php
1,000 in interest for that year.

3) Amortized Loan
requires the debtor to repay parts of the loan amount over time. The debtor pays the interest each
period plus fixed amount. The process provides loan payments on regular principal reduction.

For example: Suppose a business takes out a Php 50,000, five-year loan at 9%.
The loan agreement calls for the debtor to pay the interest loan on the balance each year and to
reduce the loan balance each year by Php 10,000.
Because the loan amount declines by Php 10,000 each year, it is fully paid in five years.

Beginning Ending
Year Principal Paid Interest Paid Total Payment
Balance Balance
1 Php 50,000 10,000 4,500 14,500 40,000

2 40,000 10,000 3,600 13,600 30,000

3 30,000 10,000 2,700 12,700 20,000

4 20,000 10,000 1,800 11,800 10,000

5 10,000 10,000 900 10,900 0

Total 50,000 23,500 63,500

Notice that in each year, the interest paid is given by the beginning balance multiplied by the interest
rate. Also notice that the beginning balance is given by the ending balance from the previous year.

The most common way of amortizing a loan is to have the borrower make a single, fixed payment
every period. Almost all consumer loans, like car loans and mortgages, work this way.
For example: suppose our five-year, 9% Php 50,000 loan was amortized this way,
the illustration is as follows:
Amortization = Php 50,000
/ 3.8897 (refers to
Table on Present Value of Annuity for t periods)
= Php
12,845.46

The debtor will therefore make five equal payments of Php 12,854.46. On the first year, the interest is
Php 4,500; therefore total principal is Php 8,354.46. (Php. 12,854.46 - 4,500).

Summary of the payment schedule is as follows:

Beginning
Year Principal Paid Interest Paid Total Payment Ending Balance
Balance
1 Php 50,000 12,854.46 4,500 8,354.46 41,645.54

2 41,645.54 12,854.46 3,748.10 9,106.36 32,539.18

3 32,539.18 12,854.46 2,928.53 9,925.93 22,613.25

4 22,613.25 12,854.46 2,035.20 10,819.27 11,793.98

5 11,793.98 12,854.46 1,061.46 11,793.98 0

Total 64,272.30 14,273.29 50,000

LONGTERM SOURCES OF CAPITAL: BONDS

 BONDS are form of longterm debt, a liability of a company that has the specified principal
value and maturity date.
 Its Principal is also called the face value, in which the amount of the bond is printed on the
face, or its par value.
 Company (as the debtor) is the bondissuer; Investor (as creditor) is the bondholder.
 Bondholders receive interest (yield expressed as current yield or yield to maturity.
 Redemption of interest can be semi-annual or annual express in simple annual interest.
 Covenants are stated in a legal document known as indenture and may vary on the financial
condition of the borrower. May include:
• Requirement to periodically retire portions of the debt;
• Restriction on issuing lower-cost bonds to retire the current issue;
• Limits on the issuance of additional debt;
• Limits on dividend payments or stock buybacks if the cash outflow would decrease the
company’s ability to pay future principal and interest;
• Description of the minimum financial ratios the company must maintain.
The bond is said to be in default if the issuer does not make the required interest or principal
payment, or if it violates one of the covenants identified in the indenture.
A trustee is appointed for each publicly-held bond, whose main task is to monitor that the terms in
the indenture are met and to work with the firm in cases where intervention is needed.
Commercial banks commonly act as trustees for major corporate bond issues.
 Investment bankers charge fees for the various services they provide during the financing
process
 The firm should determine how much capital they would like to generate with the bond issue
and the cost of the borrowing.
 The company can also decide if it will retire a certain portion of the bond issue each year, or
whether it plans to repay the entire principal of the maturity date.

TYPES OF BONDS
A) ACCORDING TO TYPE OF SECURITY
1) SECURED BONDS or MORTGAGE BONDS
 Are backed by the firm-owned property.
 Most common type of secured bonds and backed by real estate assets.
 If the firm defaults on its bond, the bondholders-represented by the trustee-could seize the
asset and sell it to settle the debt.
 In some cases, if the bondholders are forced to sell the assets used as collateral, they may
receive liquidation value rather than the market value, and there may not be a guarantee that
the sale would cover the indebtedness of the issuing company.
 Mortgage bonds are secured by a lien on specifically named property such as land, buildings,
equipment, and other fixed assets specifically pledge as security. Specific types are:
• Real estate which Real estate mortgages further sub-classes may include:
• Senior liens which have prior claim to fixed assets pledge as security, or sometimes called
first mortgage bonds
• Junior liens have subsequent claims to fixed assets pledge as security, or subordinate
claim to the senior liens. Also called second-mortgage or third-mortgage bonds
• includes land and property attached to the land.
• Chattel which consists of personal and movable property.
Also, real estate mortgage maybe classified according to type of issue:
• Closed-end issue wherein subsequent issues on the specific property pledge as collateral
are not allowed
• Open-end issue permits issuance of additional bond or series of issues to be made under
the original mortgage secured by a single lien.
• Limited open-end issue allows additional bonds to be sold after the original issue, but
stipulates a maximum amount. Issue becomes closed when the specified amount of bonds
have been issued.
2) DEBENTURES
Unsecured bonds longterm bonds of a corporation.
• More risky than secured bonds;
• Subordinate debentures are those with lower payment in hierarchy.
• Convertible bonds have stated maturity value and coupon rate, but it offers the investor the
opportunity to convert the debt to equity at stated periods of time.
• If stock prices appreciated, bondholders may be willing to convert.
For example: Akiko Manufacturing could offer a Php 1,000,000- 10-year bond, convertible into 20
shares of common stock on its fifth year. The firm may be benefit from the conversion feature
because convertible bonds carry a lower rate of interest than subordinate bonds without the
conversion feature.
3) Assumed bonds are those by the surviving corporation. They remain unchanged with the same
protection on mortgage lien given to the bond.
4) Guaranteed bond is a type in which payment of interest, or principal, or both, is guaranteed by
one or more individuals or corporations. This assures additional protection on the part of the
bondholder.
5) Joint bonds are owned by several companies. The same property may be used as security for a
bond issue. The companies bind themselves jointly as debtors in this issue.

B) ACCORDING TO PARTICPATION IN EARNINGS

1) Municipal bonds or Government bonds
 Bonds that are issued by a country, cities, municipalities or any authorized public authority
(school boards, highway commissions or port districts).
 Municipal bonds are able to offer lower rate of interest than corporate bonds.
 These bonds are offered to individuals who pay high marginal tax rates.
TYPES OF MUNICIPAL BONDS
1. General obligation bonds are backed by the full faith and credit of the issuer.
2. Revenue bonds derive funds from the income produced by the funded asset
2) Pure Discount Bonds
 Promises to pay a certain amount at a specific time in the future.
 Before maturity, the instrument trades at a price that is less than the promised future payment.
o Bond discount is the difference between the par value and selling price.
o A Coupon bond was for most corporate bonds, where interest payments are made regularly,
as scheduled, between the original issue date and maturity date.
3) Registered Bonds
 Identify the names of the owners in the transfer books of the company.
 The owners received payment for interest and principal by checks drawn in their favour.
4) Income Bonds
 Have fixed rate of interest payable only if earned and declared by the directors.
5) Participating Bonds
 Stipulate a fixed coupon rate but which also provides a method of receiving additional income
over and above minimum sum.
6) Convertible Bonds
 Are generally debenture bonds or junior-lien mortgage bonds where the owner has the option
to exchange his bond for a specified number of shares of common stock, preferred stock or
other types of bonds.
7) Bonds with Warrants
 Has the option or right to purchased stock at a stated price during a stipulated period.
Detachable warrants are sold or exercised apart from the bond, while non-detachable warrants
cannot be sold or exercised separately from the bond.

C) ACCORDING TO METHOD RETIREMENT

1) Serial Bonds
 Mature annually or semi0annually insatead of all on a single date.
2) Sinking Fund Bonds
 Requires the issuer to deposit annually certain sum of money with the trustee of the issue for
the retirement of the part of the issue before maturity.
3) Callable Bonds
 Have the provision that the issue can be cancelled or called. The call privilege enables the
issuing company to pay off a bond issue prior to maturity.
4) Perpetual Bonds
 Those which the holder cannot redeem payment. This is commonly used in public finance,
where the debtor ( the government) may be assumed to have permanent existence.

All bonds can be classified as premium, par or discount bonds, depending on whether their current
price exceeds, is equal to, or is less than the face value. At maturity, the price o the bond must equal
the principal amount to be returned.
 If a bond is selling at a premium, the price must fall toward face value as maturity approaches,
even if interest rates do not change.
 If a bond is selling at a discount, the price must rise toward the face value as maturity
approaches, even if interest rates do not change.
The effect of a given change in interest rates on the price of the bond depends upon these variables:
o The maturity of the bond
o The coupon rate
o The level of interest rates at the time of the change in interests rates.
Interest Rate Risk
 The threat that a bond’s price will change due to a change in interest rates.
 The bonds prices move inversely with interest rates.
 The price sensitivity of bonds increases with maturity, but it increases at a decreasing rate.
 Forward rates of interest are rates for future time periods that are implied by currently available
spot rates. A spot rate is a yield prevailing at a given moment.
 The risk structure of interest rates analyzes the differences in risk among different classes of
bonds.
 The risk premium is the yield differential between risk-free treasury bonds and risky corporate
bonds.
 Default risk is the chance that one or more promised payments on a security will be deferred to
miss altogether.