Mba 503 Long Term Financing
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Running Head: METHODS OF LONG-TERM FINANCING
Long-Term Financing Paper
Methods of Long-Term Financing
In today’s business environment, firms must effectively use every strategy possible to remain competitive in their respective markets and maximize investor wealth. This is especially true when considering options for increasing the financial capital required for growth. Although there are many differing methods to raise financial capital, generally speaking, financing instruments fall into one of two categories: debt or equity (Securities Law, p. 1, 2008).
Both debt and equity represent opportunities to increase capital and provide a means for business expansion, each instrument has particular advantages and setback that must be successfully managed in order to achieve the firm’s desired result of maximized wealth through growth. One important item to consider when examining methods for raising capital involves the, “dilution of ownership that occurs by using equity instruments versus the obligation to repay which comes with the use of debt instruments” (Evans, p.1, 2005). The ability to manage the ratio of debt to equity in long-term financing, represents a critical decision making process that will determine the success or failure of a firm’s business ventures, as well as, determine who receives the benefits of the expected increase in wealth.
When considering avenues for expansion, long-term financing strategies provide the best opportunities to maximize investment dollars for use towards increasing production and or new product development. Long-term financing involves the use of debt and or equity instruments with greater than one-year maturities, and often serve as vehicles to create additional capital. Equity instruments allow for additional freedom with regard to cash flows, they also provide for dilution of ownership. Equity instruments involve the use of stocks to raise funds and are typically calculated using either the Capital Asset Pricing Model (CAPM) or the Discounted Cash Flows Model (DCFM). According to Forbes Magazines’ Investopedia, the CAPM states, “that the expected return of a security or a portfolio equals the rate on a risk-free security plus the premium” (Investopedia, 2008). This model works on the premise that if the expected return does not meet or exceed the required return, the investment should not be undertaken. This principle is commonly attributed to the famed economist, William Sharpe. As noted in article, Revisiting the Capital Asset Pricing Model Theory by Jonathon Burton of Stanford University, Sharpe provided much of the basis for what is now termed the Capital Asset Pricing Model, which explains the relationship between how securities are priced based upon their potential risk and returns. Burton goes on to indicate that Sharpe espoused that every investment carries two distinct risks, the CAPM states. One is the risk of being in the market, which Sharpe called “systematic risk”. This risk, later dubbed “beta”, cannot be diversified away. The other “unsystematic risk, and is specific to a companys fortunes”. Since this uncertainty can be mitigated through appropriate diversification, Sharpe figured that a portfolios expected return hinges solely on its beta—its relationship to the overall market. The CAPM helps measure portfolio risk and the return an investor can expect for taking that risk (Burton p.1, 1998). This relationship can be mathematically described using the following equation as articulated by Block and Hirt in the text Foundations of Financial Management (Chap. 11, p.7):
Kj=Rf+B(Km-Rf)
Where: Kj= return on company’s common stock
Rf= risk-free rate of return, usually the current rate on Treasury Notes
B= Beta coefficient, usually measuring the historical volatility of an individual
stock’s return relative to a stock market index, a beta greater than 1 indicates greater volatility while the reverse would be true for a beta less than 1
Km= return in the market as measured by an appropriate index.
As Block and Hirt indicate with the above formula, the assumption with this model is the rate of return or premium demanded by investors is directly proportional to the perceived risk associated with the common stock. Of particular importance in this equation is the Beta coefficient. This value represents a measure of stock volatility for the individual firm, relative to an equivalent indicator of similar stocks. The higher the Beta coefficient, the greater the risk involved. When the risk associated with a particular stock is equal to the market price index, the beta coefficient will equal one (1). In similar fashion, the higher the beta coefficient, the more volatile the investment will be.
Another means to determine the cost of equity is the Discounted Cash Flow Model (DCFM). This method of determining the cost of equity assumes that a firm’s stock price is equal to the present (discounted) value of all expected future dividends from the investment. According to the business think-tank, Value-Based Management, the DCF for an investment,
“is calculated by estimating the cash available to pay out and the cash received in the payback, including the times that payments are expected. Each cash transaction must be discounted by the opportunity cost of capital over the time between now and when payment is received” (Jan. 6, 2008).
This explanation is also articulated by Freeman and Gagne, who state that “the modern financial theory contends that the price of a firm’s stock is the present value of the future cash flows discounted at an appropriate interest rate” (1992, p.141).
There are advantages and disadvantages of using either the CAPM or the DCFM, they both represent the application of data from single or groups of companies to evaluate the current value of a single company.
As indicated by Burton (1998, p. 6),
“the CAPM is more complicated, but more objective while the DCF is more simplified but subjective; however, the assumptions required for the DCFM are sometimes too strong for firms. For example, the DCF assumption that future dividends will grow at a constant rate in perpetuity is not always