Long Term Fiancing
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Introduction
Long-term financing strategies help ensure that the money invested today will earn more than or equal to the amount invested. The capital asset pricing model (CAPM) and discounted cash flow method (DCF) will be compared. The debt and equity mix help a company optimize its wealth. The debt and equity mix will be examined along with characteristics of the financial market, and debt and equity instruments. Finally, long-term finance alternatives such as stocks, bonds, and leases are discussed.
Capital asset pricing model vs. discounted cash flow method
Two methods can be used to calculate the required return on common stock. The first method is capital asset pricing model, or CAPM. In CAPM, the required return on common stock is reached by adding the risk-free rate of return to historical validity of the return. The historical validity of the return is calculated by subtracting the return in the market from the risk-free rate of return.
The discounted cash flow method, or DCF, “uses 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 potential for investment,” (Investopedia, 2007). A good opportunity exists when the potential for investment is greater than the current cost. The DCF method is used to account for the time value of money, this means the value of a dollar today has a lesser value in the future, all else being equal. The following chart shows how the two methods are calculated and what drawbacks may exist.
Description
Formula
Drawbacks
Capital Asset Pricing Model (CAPM)
“CAPM relates the risk-return trade-offs of individual assets to market returns,” (Block & Hirt, 2005).
Kj = + Km + e
Kj = Return on individual common stock of a company
= Alpha, the intercept on the y-axis
= Beta, the coefficient
Km = Return on the stock market (an index of stock returns is used, usually the Standard & Poors 500 Index)
e = Error term of the regression equation
CAPM does not measure all types of assets easily.
Discounted Cash Flow Method (DCF)
DCF uses future cash flow and discounts it to get the present value.
CF1 CF2 CFn
(1 + r)1 (1 + r)2 (1 + r)n
CF = Cash Flow
r = discount rate (WACC)
The DCF method should not be used for long-term investing because the estimated value is difficult to predict as time increases.
Debt and Equity Mix
It can be said that one of the main strives for a company or firm is to maximize wealth. In order for the firm or company to maximize wealth, it must gain capital by diversifying its financial portfolio. Few of several ways to diversify the financial portfolio is through the sale of products or goods, the purchasing of equipment, financing or through investments. A companys financial portfolio must be carefully projected in a way so the firm is guaranteed gained capital.
When the correct financial projection is made, a firm can use the information in order to make the best decisions with respects to earning profits. Both debt and equity can be used as avenues for financing. Debt or equity could be looked and financed separately, however, they can also be used together. When making the decision to do a debt/equity mix such factors as costs come in to play. An example of debt financing is bank loans; this type of debt allows leverage of company profits. An example of equity could be through money received through purchased shares from the company. “The optimal mix of debt and equity has to be tailored for each situation. This requires some sophistication in financial modeling…The goal is to find the debt/equity mix that provides the highest expected long-term shareholder value” (Dynamic, 2007).
Costs serve as a key feature when considering a debt/equity mix. Debt costs unlike equity must be repaid or refinanced. “The cost of debt is measured by the interest rate, or yield, paid to bondholders” (Block & Hirt, 2005). When a firm is issuing debt, the yield to maturity should be calculated. Other costs to consider are costs of preferred stock, cost of common equity and cost of retained earnings. Preferred stock is a constant annual payment without maturity, nor is it tax deductible. Cost of common equity is the current dividend over the market price. Lastly, “accumulated retained earnings represent the past and present earnings of the firm minus previously distributed dividends. Retained earnings, by law belong to the current stockholders” (Block & Hirt, 2005). With respects to the debt/equity mix, it is important to consider how cost would readily affect profit or capital gain.
Debt and Equity Instruments
“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…The equity market (often referred to as the stock market) is the market for trading equity instruments,” (Econ, 2005). Examples of debt instruments are bonds and mortgages. Bonds are an investment in a since that though they have to be purchased at a market rate, there is a market for returns. An example of equity instruments is stocks. Stocks carry more risk than bonds, yet the purchaser unlike the bondholder gains ownership in a firm. Stocks have more potential for higher returns than bonds. Both are important because the bond market is where interest rates are determined and stocks effect both investment spending and consumer spending decisions (Econ, 2005).
Long-Term Financing Alternatives
“Long-term financing is defined as providing capital deficit business funds for a period over one year. The source of long term financing comes from debt, equity and derivatives” (UniXl.com, 2001). “Many businesses must find out the source of long-term financing to determine the distribution cost of capital improvements over the years” (Hrg-inc.com, 2007). Some long-term financing alternatives businesses can consider are bonds, stocks, and leases to name a few.
Bonds are considered public trade securities