Long Term Financing Alternatives
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Running Head: Long Term Financing Alternatives
Long Term Financing Alternatives
Shellie N Phillips, Elias Hernandez, and Deborah Stewart
University of Phoenix
MBA 503
Joey Oliveri
March 19, 2008
Introduction
Firms need Capital to finance their assets. The need for long-term capital requires the firm to assure itself of having adequate capital at all times. Financing can be debt based, equity based or a mix of both. Debt is the cheapest form of financing, but it should be used only within reasonable limits, because use of debt beyond a reasonable point may increase the firm’s financial risk and drive up the costs of all sources of financing. This paper discusses the concepts of capital pricing models, debt/equity mix and dividend policy, evaluates various long-term financing alternatives and characteristics and costs of financial instruments, which are helpful to a firm intending to expand in the future.
Capital Asset Pricing Model (CAPM) with the Discount Cash Flow Methods
What is the cost of capital and how is it measured, what is its price? In order to get an accurate price of what capital is costing the firm the liability must be weighed out against its benefit. If the cost out weighs the benefit then there would be a negative return. When discussing capital funds we must consider the vehicles in which capital is raised. There is a price for Bonds, Preferred Stock, and Common Stock. The cost of debt or simply the cost of financing is arrived to by the interest rate, or yield, paid to bondholders. Preferred Stock is quite comparable to the cost of debt, the payment is consistent every year; however, there is no maturity date on the principle. The cost of a preferred stock is simply determined by the dividend over the current price. The cost of Common Equity (Common Stock) is much the same except that it Current Dividend over Market price. There are some variations and other factors that can be considered in determining this cost. There is no perfect model in evaluating stocks so many models competing for attentions. We will take a look at two popular models.. The Capital Asset Pricing Model (CAPM) and the Discount Cash Flow Methods (DCF). Each model has strengths and weaknesses which will need to be understood in order to determine which one to use. As all situations are unique, the methods chosen will be governed by the specifics of the situation.
The general idea behind CAPM is that stockholders need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free rate and compensates the stockholders for placing money in the company over a period of time. The other half of the formula represents risk and calculates the amount of compensation the stockholders needs for taking on additional risk. This is calculated by taking a risk measure that compares the returns of the asset to the market over a period of time and to the market index or premium. Another valuation method used to estimate the price of stock is DCF analysis DCF methods use future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the value of the stock. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one. Both methods or models need to be looked at to determine what the true value of a stock is.
Debt to Equity Mix and Dividend Policy
Corporations grow and so does their responsibility to the failure to integrate acquisitions and relationships successfully could hinder the success of the firm. Future acquisitions may be require the additional capital. This may be the company’s earnings or additional debt or equity financing. As the company continues to undertake strategic growth initiatives, one can reasonably assume that it will also continue to acquire the costs of additional in-process projects (Boston Scientific 2006 Annual Report). Reducing large amounts of debt, may require a portion of its operating cash flow to repay the debt. One way to pay large amounts of debt is to identify cost improvement measures, allowing for a better quality of revenue (profit margin). A company can also redistribute resources to better sustain growth goals. The firm could sell certain non-strategic assets and implement other strategic initiatives.
Dividends can be unattractive to investors because the value can fluctuate. The argument against dividends is based on the belief that a firm who reinvests funds (rather than pays it out as a dividend) will increase the value of the firm as a whole and consequently increase the market value of the stock. (Investopedia.com, 2003). However, there are companies that do pay out dividends. If historically a company declares dividends, not paying dividends would have a negatively affected.
Characteristics and cost of debt and equity instruments
Many different types of instruments exist that an emerging business may issue to finance its growth. In general, financing instruments fall into one of two categories—debt or equity.
Although certain exceptions exist, debt instruments generally represent fixed obligations to repay a specific amount at a specified date, together with interest. In contrast, equity instruments generally represent ownership interests entitled to dividend payments, when declared, but with no specific right to a return on capital. Within each of these two general categories, there exist a wide variety of rights, privileges, and limitations that may be established by the issuing company.
The debt market is the market where debt instruments are traded. Debt instruments are assets that require a fixed payment to the holder, usually with interest. Examples of debt instruments include bonds (government or corporate) and mortgages.
The equity market (often referred to as the stock market) is the market for trading equity instruments. Stocks are securities that are a claim on the earnings and assets of a corporation. An example of an equity instrument would be common stock shares, such as those traded on the New York Stock Exchange.
The cost of debt is computed by taking the rate