Long-Term Financing
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Long-Term Financing
An established company is considering expanding its operations, and to achieve their business objectives, the company will require additional long-term capital financing. Long-term financing involves debt or equity instruments with greater than one-year maturities, and the cost of this long-term capital can be calculated using either the Capital Asset Pricing Model (CAPM) or Discounted Cash Flows (DCF) Model. This report will consider the costs and characteristics of various long-term debt and equity financial instruments, and discuss financial prudent debt/equity ratios. Various dividend and principal repayment policies will also be considered for corporate bonds.
Economist William Sharpe Won the Noble Prize in 1990 for his research on what devolved to be the CAPM theory on estimating the cost of capital for firms and evaluating the performance of managed portfolios. Sharpe “provided much of the basis for what is now termed the Capital Asset Pricing Model (CAPM)” (Frängsmyr, 1991) through a financial model that explains how securities are priced based on their potential risks and returns. “CAPM is a linear relationship between returns on individual stocks and stock market returns over time” (Block & Hirt, 2005, p. 342). Although more than one formula exists for the CAPM, the most common is referred to as the market risk premium model presented below (Block & Hirt, p. 343):
Kj = Rf + β(Km – Rf)
Where:
Kj = return on companys common stock
Rf = the risk free rate of return (short-term Treasury bill securities),
β = beta coefficient, or historical volatility of common stock relative to market index, and
Km = average market return based on an appropriate market index.
The market risk premium formula assumes that the rate of return or premium demanded by investors is directly proportional to the perceived risk associated with the common stock. The beta coefficient is a measure of stock volatility for the individual firm, relative to an equivalent market indicator of similar stocks. Higher betas mean greater risk. When the risk associated with a particular stock is equal to the market index risk or average risk across multiple stocks, the beta coefficient (β) will equal 1.0, and Km = Kj. More volatile stocks will have a beta coefficient greater than 1.0, whereas less volatile stocks will have a beta less than 1.0. If the risk free rate of return (Rf) and average market return (Km) are considered fixed, then the required rate of return for company stock can be calculated for the security market line (SML) or required rate of return. As an example, if the market risk premium (Km – Rf) is 6% and a risk free rate of return (Rf) is 4%, then the required rate of return would equal 10% for β = 1, and 16% for β = 2.
The Discounted Cash Flow (DCF) Model is another “standard way of determining the cost of equity. It assumes that a firms current stock price is equal to the present (that is, discounted) value of all expected future dividends from the investment” (Utility Regulation, 2006). “Modern financial theory contends that the price of a firms stock is the present value of the future cash flows discounted at an appropriate interest rate” (Freeman & Gagne, 1992, p. 141). To calculate the current stock value, we must calculate the present value of future dividends and growth in the value of the stock at some future date. The discount rate used for this present value calculation is the opportunity cost of a forgone investment over the same period, or the weighted average cost of capital (WACC) for the firm. Discounted cash flow equations for various financial instruments are presented in the paragraphs that follow.
Both the CAPM and DCF models involve applying data from a single or group of companies, to evaluate the current stock value of a single company. By definition, CAPM is more objective and complicated, and requires more calculation and data from the market and historical documents. DCF is more subjective and simplified; however, the assumptions required for DCF are sometimes too strong for a specific firm. One such DCF assumption is that future dividends will grow forever at a constant rate (in perpetuity). Since this assumption is not always true, the DCF method gives a more qualitative estimate of the cost of capital.
The cost of capital assessment may include a budgeting process of evaluating projects that require a significant investment of current capital in exchange for a payoff that may not materialize for years (Vance, 2003). Each project must be capable of providing a return on investment equal to or greater than the cost of capital to fund the project. As with any new undertaking or business expansion, the use of long-term financing includes some risk to the corporation. This financial risk increases as the debt portion of the capital structure increases.
Debt-equity mix is a term used to describe the ratio of debt to equity in the capital structure of the firm. Debt and equity financing differ in nature and complement each other. Debt needs to be repaid with interest, and the principal must be paid off at maturity or refinanced. Debt financing does not dilute the stockholders interest in the company, but carries a financial risk if a downturn in business occurs. Equity financing involves new issues of preferred or common stock, and dilutes the existing stockholders interest in company earnings and value. “In choosing the right mix of debt and equity, you must consider three issues: your projected cash flow to repay debts, the relative cost of the different types of financing, and the impact of sacrificing some ownership and control” (Strategis, 2006).
The appropriate combination of debt and equity means an optimum capital structure, and the lowest weighted average cost of capital (WACC). The optimum range is dependent on investors perception of an appropriate level of debt for a particular industry, and generally falls within the 30% to 50% percent range of overall capital structure. Because debt is typically the cheapest form of financing capital, moderate increases in the debt load may reduce the WACC. Beyond some point, however, the additional financial risk to the company and investors drives up the cost of all future debt and equity financing.
Debt financing can take the form of bank loans or new issues of corporate bonds. The corporate bond represents the basic long-term debt instrument for most large corporations (Block