Long Term Financing
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Long-Term Financing Paper
Introduction to Finance and Accounting
February 27, 2007
Long-Term Financing Paper
For a publicly traded company, shareholder value is the part of its capitalization that is equity as opposed to long-term debt. In the case of only one type of stock, this would roughly be the number of outstanding shares times current share price. Things like dividends augment shareholder value while issuing of shares (stock options) lower it. This Shareholder value added should be compared to average/required increase in value, also known as cost of capital. For a privately held company, the value of the firm after debt must be estimated using one of several valuation methods, such as discounted cash flow or others. Discounted Cash Flow (DCF) is used to determine a companys current value according to its estimated future cash flows. Forecasted free cash flows (operating profit + depreciation + amortization of goodwill – capital expenditures – cash taxes – change in working capital) are discounted to a present value using the companys weighted average costs of capital. The Capital Asset Pricing Model (CAPM) is used in finance to determine a theoretically appropriate required rate of return (and thus the price if expected cash flows can be estimated) of an asset, if that asset is to be added to an already well-diversified portfolio, given that assets non-diversifiable risk. The CAPM formula takes into account the assets sensitivity to non-diversifiable risk (also known as systematic risk or market risk), in a number often referred to as beta (в) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. This paper focuses on long-term financing advice for an organization.
Capital Asset Pricing Model (CAPM)
The capital asset pricing model is an optional course of action many corporations uses in determining the required return on common stock. Common stock is the remaining equity in a corporation that is normally sold at a price all investors can afford. Many corporations, however, encourages the use of the capital asset pricing model while others deeply opposes the validity of the model. The capital asset pricing model requires a formula to calculate the required return for common stock. This formula is: Kj = Rf + B (Km – Rf) where
Kj = Required return on common stock
Rf = Risk-free rate of return
B = Beta coefficient.
The beta measures the historical volatility of an individual stocks return relative to a stock market index. A beta greater than 1 indicates greater volatility than the market, while the reverse would be true for a beta less than one.
Km = Return in the as measured by an appropriate index (Block & Hirt, 2005).
The capital asset pricing model is a model that relates the risk-returns trade-offs of individuals assets to market returns (Block & Hirt, 2005). In our growing market today, common stock returns have used the capital asset pricing model because of the availability of stock prices, and because of the stocks being reasonably priced. Theres an assumption in corporations that the capital asset pricing model includes all assets, but in reality it is not easy to account for the profits on all assets in a corporation. Nor is it easy to find a market index that will include all assets.
Discounted Cash Flows Model
There are different discounted cash flow methods that are used to determine the cost of a corporations capital. Some of the discounted cash flow models are: 1) Cost of Debt – in a corporation the cost of debt is calculated by the interest rate, or yield paid to bondholders, where a payment is made every year. In issuing new bonds the firms interest rates will be different from time to time because of investors demanding discount rates to earn a profit. Cost of Preferred Stock is comparable to the cost of debt, it is also measured by the interest rate or yield, with one exception, and there are no time limits on payments. To find out the yield on preferred stock, you divide the annual dividend by the current price. This calculation indicates the rate of return to preferred stockholders, and the yearly cost to the firm for the preferred stock issue. To determine the cost of preferred stock, firms use the following formula: Kp (cost of preferred stock) = Dp divided by Pp – F, where
Kp = Cost of preferred stock
Dp = The annual dividend on preferred stock
Pp = The price of preferred stock
F = Flotation, or selling cost
Capital Acquisition and Investment Decision Making is financial capital that consist of bonds, preferred stock, and equity that appears on all corporations balance sheet listed under liabilities and equity. The money the corporation earns from their bonds, preferred stock, and equity is invested in the corporations long-term assets. Corporations must balance their debt and equity to attain the least cost of capital.
Financial Instruments
Financial instruments are either a real or virtual document representing a legal agreement involving some sort of monetary value. Financial instruments can be categorized by form depending on whether they are cash instruments or derivative instruments. Cash instruments are financial instruments whose value is determined directly by markets. They can be divided into securities, which are readily transferable, and other cash instruments such as loans and deposits, where both borrower and lender have to agree on a transfer. Derivative instruments are financial instruments which derive their value from some other financial instrument or variable. They can be divided into exchange traded derivatives and over-the-counter (OTC) derivatives. Alternatively they can be categorized by “asset class” depending on whether they are equity based (reflecting ownership of the issuing entity) or debt based (reflecting a loan the investor has made to the issuing entity). If it is debt, it can be further categorized into short term (less than one year) or long term. Foreign Exchange instruments and transactions are neither debt nor equity based and belong in their own category. Combining the above methods for categorization, the main instruments can be organized