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So we are starting with this example from a corporate finance one,

this example was in module two when we talked about financial planning.

I think it's simple enough that you can understand this even if you haven't

looked at that example, but if you have any questions or

if there's anything you want to check.

The example is the module two of corporate finance one, okay.

And what the example is about it's a financial planning model for PepsiCo.

Under the assumption that PepsiCo wants to invest $3.5 billion in 2015.

And $64.5 billion in 2016.

Assuming we are in the December 2014.

And the question that we asked was whether PepsiCo could

finance this expansion without issuing new finances, right?

Which is the key topic we're going to talk about in this lesson is,

how is PepsiCo going to get these new findings but

previously, what we done, so here you have our planning model, right.

So you have the capital expenditures 6.5 billion in 2016 that's the big one.

And then what we did in this financial planning model was to think

about whether PepsiCo could finance it using only their own capital,.

So can PepsiCo finance this out of it's own cash flow and cash balances, right.

So the way we did this is we forecasted cash flow from operations

using a simple forecasting model, right?

We included the capital expenditures under

the assumption that there is no new financing in the next few years.

So you can see that it's all zeros here in 2015 and 2016.

The answer we got is that PepsiCo would have a negative

change in cash of about 2.7 billion dollars by 2016.

So the answer right is that,

if PepsiCo does not want to reduce it's cash holding, right.

Assuming that the company has a target amount of cash holding that it

wants to keep for example, right.

Then PepsiCo would need to raise new funds, right.

Because of this expansion plans

the company would need to raise some money, right?

Some new funds, let's say that the amount that PepsiCo will raise is $5 billion.

We talked about this in module one as well.

It might make sense for

a company to raise a little bit more than what it needs, right?

So that it has a little bit of a financial cushion, okay?

Again, we talked about this in module two of corporate finance month, right.

So this is the new question we are talking about now.

We are going to think about this very important

choice that companies have to make when deciding how to raise new financing, okay.

Which is whether you are going to go to the debt markets or

whether you're going to issue equity, all right?

So that's the major topic of this module, of this session, and

we're going to start with this example.

The first thing we're going to do is to talk about mechanics, okay?

So we have the financial statements ready.

We have our financial planning model ready.

So what I want to do with you, and I think it's a very useful exercise.

Is to look at the financial statements and figure out what will happen

after PepsiCo issue debt in equity, okay.

Let's start with debt.

Suppose that PepsiCo issues $5 billion in new debt, okay.

And suppose that the interest rate is 4%.

I doesn't have to be exactly that, but let's say that those are the numbers,

right.

That means that PepsiCo will pay new interest of $2 million per year, right.

So how will that affect the financial statements?

You can check, this is the old financial statement,

it has the interest expense here, right.

That's the item, okay.

The new income statement is going to have an increased the amount of interest

expense.

Right, so you have 200 million additional interest expense.

So I have it here in bold.

PepsiCo will have to pay additional interest,

because you financed the new investment using that.

Right, so the interest expenses here.

The interest expenses of course going to reduce your earnings, right.

So you pay interest, your earnings, your net income is going to go down.

You can check that.

All right.

In terms of the cash flow statement, right.

So your earnings are lower, it's in bold.

That's the top of the cash flow statement, right.

And then we can just derive the other items of the cash flow statement, right.

We're going to lower the cash flow from operations as well, right.

We have the capital expenditures, but this is the key thing, right.

Because PepsiCo borrowed $5 billion in the year of 2015.

Let’s say that PepsiCo did this right at the beginning of 2015, when

you get to the balance sheet at the end of 2015, the balance sheet and

in the cash flow statement we will also reflect that $5 billion, okay?

So the PepsiCo has net borrowing,

a positive net borrowing of $5 billion, right?

Which means that now you're going to have a positive cash flow from financing and

if you recalculate the numbers,

what will happen is that now we have a positive change in cash.

They're right at the bottom.

They're either positive changing cash of $5.1 billion in 2015,

so that will be more than enough to compensate for the negative, right.

The number is there.

The negative changing cash in 2016, so

now PepsiCo could definitely have enough funding, right?

So that was that.

Let's talk about equity, okay?

Issuing equity, of course means going to the market and

selling new shares, at least for a public company, right.

Where the public company would do,

is to sell new shares of the company in the marketplace.

The current stock price of PepsiCo at the time that we did the financial planning.

Although it's not necessarily when you are watching this lecture but at that time.

PepsiCo stock was trading at $94 a share.

So what that means is that if PepsiCo wants to get $5 billion dollars in new

equity.

It will have to issue [COUGH] 53.191 million share.

Okay, so you can do the math there quite straightforward.

Just dividing five billion by $94 of a share, okay?

So what changes?

Now there is no new interest experience, right?

So the income statement if you think about it.

The income statement is going to be exactly the same, you're operating income,

by definition doesn't depend on financial cash flow, right?

Your interest is not changing.

That means that your earnings is going to be the same.

There is no change in your earnings, right?

Cash flow statement.

So instead of the borrowing, right?

So we have $5 billion for net borrowing here.

Now we're going to have $5 billion for the net issuance of stock.

That means that PepsiCo is going to the market to raise new equity, right?

And that's reflected in the cash flow statement.

Right again, when you to the bottom of the casual statement,

what we'll see is that, now PepsiCo is going to have a positive changing cash.

So definitely the company have enough funding, right?

To finance this, the expansion plan, right?

But now think about the following but there is a little trick here.

We saw the income statement, the casual statement, it all seems good, right?

Now PepsiCo has a higher changing cash now, so

you have enough cash to finance the new investment, right.

Your profits haven't changed, right.

So you might be wondering at the point what is the cost of issuing new equity?

So I want to give you a little bit of time to think about that.

What's the cost of issuing new equity?

The cost of issuing new equity is that the number of shares

outstanding is going to go up, right.

So as we figure out and we're doing these calculations, PepsiCo is going to have to

increase the number of shares outstanding by 53.19 million, right.

So the company has more shares outstanding.

What that means is that,

the profits that people produce they haven't changed it, right.

But they are going to have to be divided among a larger number of shares, right.

Issuing equity is the same thing as bringing new owners, right.

To own the same company, right.

So if you bring new owners and the company hasn't changed it then the old owners.

The people who already owned Pepsico and shares are going to own

a smaller size, a smaller fraction of the pie, right?

So the cost of issuing equity is that you are issuing new shares,

in this case, right?

And you might be thinking about dividends.

I'm sure that some of you thought, the cost of issuing equity is that we're going

to increase, somehow we're going to have to increase dividends, right?

That would be the counterpart to of that, you issue that you pay interest.

You issue equity you exchange dividends, right?

You should look at all financial planning model we actually assume that

total dividends were constant.

Dividends were not changing at all, right.

And if you think about this it actually makes sense.

Paying dividends is a choice of the company.

It's another choice, right?

In principle it's unrelated to the choice of issuing equity, right.

And if you think about the fact that PepsiCo wants to

bring new money into the company.

Maybe it doesn't make sense for

PepsiCo to increase dividends at the same time, right?

So if PepsiCo had increased dividends, then it did this

would consume part of the new funds that PepsiCo brought in from the equity market.

So maybe it wouldn't make sense for

PepsiCo to increase dividends at that point.

In fact, it's a topic of it's own, right?

In Module 2 of Corporate Finance 2, right?

We're going to spend a lot of time talking about payout policy, right?

So it's exactly the decision of how much dividends to pay.

And then we're going to have more to say about that.

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Issuing Debt and Equity – The Mechanics

Corporate Finance II: Financing Investments and Managing Risk

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