Long Term Financing Paper Final

Running head Long-Term financial backing Long-Term Financing University of Phoenix Online Introduction to Finance and accounting system MMPBL-503 James R. Sullivan November 3, 2008 Long-Term Financing An established ships company is considering prolonging its ope dimensionns, and to achieve their business objectives, the company entrust require additional long-term capital financial support. Long-term support bear upons debt or comeliness instruments with greater than one-year maturities, and the cost of this long-term capital layabout be calculated using either the Capital Asset set (CAPM) or Discounted Cash Flows (DCFM) type.The transcription will have to comp ar and contrast the Capital Asset Pricing Model with the Discounted Cash Flows Model. The skill of comparing and tell apart financial options will help evaluate and organize the debt/ lawfulness mix and dividend policy. The organization must then decide what type of long-term pay alternatives will most managely benefit. Capital Asset Pricing Model and the Discounted Cash Flows Model Capital Asset Pricing Model is a linear family between returns on individual extractions and stock market returns over time (Block & Hirt, 2005).One use of CAPM is to analyze the performance of mutual funds and other portfolios (CAPM, 2008). Although, more than one legislation exists for the CAPM, the most special K is referred to as the market risk premium model presented below (Block & Hirt, 2005) r = Rf + beta (Km Rf) Where r is the anticipate return place on a tribute Rf = the risk free regularise of return ( silver)B = beta coefficient, or historical unpredictability of frequent stock relative to market index Km = is the return order of the appropriate plus class 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. Beta measures the volatility of the security relative to the asset class. The equation is saying that investors require higher levels of expected returns to compensate them for higher expected risk.This formula lav be thought as predicting a securitys behavior as a function of beta CAPM says that if a person knows a securitys beta then they know the none value of (r) that investors expect it to have (see graph below) (CAPM, 2008). pic 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) argon considered fixed, then the required rate of return for company stock can be calculated for the 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 B = 1 and 16% for B = 2. The Discounted Cash Flow Model (DCFM) is another standard way of determining the cost of legality. It assu mes that a firms current stock price is equal to the present (discounted) value of whole expected proximo dividends from the investment (Utility Regulation, 2008). 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 group rate (Freeman & Gagne, 1992).To calculate the current stock value, 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 weighted average cost of capital for the firm. 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. CAPM is more objective and complicated, and requires more calculation and data from the market. DCF is more subjective and simplified.One such DCF assumption is that future dividends will grow forever at a constant rate. Since this assumption i s not always true, the DCF method gives a more qualitative estimate of the cost of capital. Limitations of CAPM includes, model uncertainty, it is difficult to know for sure if the use of the model is theoretically correct. stimulation uncertainty, is another limitation, it is difficult to estimate the appropriate risk premiums accurately (CAPM limitations, 2008). Limitations of the DCF model include miss growth options, options to expand and options to redirect (DCFM, 2008).Debt/ uprightness Mix Debt/ truth mix is a financing strategy used by companies to help fund the business or other investments. Most companies use a gang of both in order to ensure stability and to keep long-term cost down. Debt is the borrowing of money from other lenders such as finance companies and banks. integrated debt has increased dramatically in the last tierce decades. (Block & Hirt, pg. 468) Other forms of debt include issuing bonds and leasing. Debt has become a common item on balance wheel she et for many companies, including those dependable starting out.Debt financing allows companies to finance without having to sell stock or bring in more partners. The major benefit for debt financing, unlike with equity financing, the owner retains full ownership of their business. Bringing in more partners or stockholders in a company causes the overtaking of primary ownership and possibly the loss of the reason the company was created. Equity is another form of financing. Equity is also used by large and small companies. Equity is financed by other people. With equity financing the initial owner/borrower has a greater risk of losing their company to the partners that have become involved.On the other hand the borrower in an equity finance loan has flexibility on avengement terms and the form of repayment (ie. cash, stock, bonds or services). However, most major corporations have a mixture of debt and equity with fashioning sure they do not have to much leverage in either one. T he formula for figuring out what a companys debt-equity ratio is (Block & Hirt) Debt/Equity Ratio = Total Liabilities Shareholders Equity Dividend Policy A companys dividend policy is up to the company and the profits that are do. If the company is just starting out they may not want to pay dividends to their stockholders.A beginning company may want to reinvest any winnings that are made in order to help the company expand. In choosing either to pay a dividend to stockholders or to reinvest the funds in the company, managements first good will is whether the firm will be able to earn a higher return for the stockholders (Block & Hirt, pg. 547). When deciding on a dividend policy the stockholders preference must be considered. The stockholder may or may not want to receive dividends and may only have concern with the value of their investment at relinquishment time.If expanding a business the dividends that are normally sent out will possibly be lower to help cover the cost of e xpanding. The expansion may also cause the dividends to increase. Some investors care about he future net profit and the increase that may occur because of the expansion and earnings increase. Characteristics and addresss of Debt and Equity Instruments The purchasers of equity instruments have the rights to vote on issues, gain ownership and future earnings of the business. Examples of equity instruments are common stock, preferred stock and retained earnings. enquire Dr Econ, 2008) Common stock is a form of equity instruments, advantages are the common stockholders will share in the companys profitability, does not have to repay investment, dividends, and the votes can influence management. The disadvantages of common stock, the vote may dilute the managements interest in the corporations growth, and the non-management stockholders can increase in the voting power, and the maximum risk falls on the investor. (Raymond, 2002) The cost of common equity is important as the ultimate ownership of the firm resides in common stock (Block & Hirt, 2005).The cost of issuing new common stock is expressed as Kn = D1 / (Po F) + g D1 = First year common dividend, Po = Price of common stock, F = Flotation selling costs, g = Constant growth rate in earnings (Block & Hirt, 2005) Preferred stock is another form of equity instruments, advantages are stocks offers stipulated dividend on an annual or semi-annual basis, preference rights over common stock and dividend payments and liquidating distributions. The dividends can accrue at a certain rate and paid on a cumulative basis.The disadvantage includes a subordination of dividends to be paid on common stock and limitations on the use of corporate fund to the effect that pre-established dividend payments. (Raymond, 2002) The cost of issuing new preferred stock is Kp = Dp ( Pp F) Where Dp = Preferred dividend, Pp = price of preferred stock, and F = Flotation selling costs. (Block & Hirt, 2005) Retained earnings are equivale nt to past and present earnings of the firm minus previously distributed dividends (Block & Hirt, 2005).In order to convince shareholders that earnings will equal larger dividends and equity later, it is important to calculate the present value of projected future cash flow. The equation for cost of retained earnings is equivalent to the cost of subsisting common stock Ke = D1 / Po + g This can be used to reacquire outstanding treasury stock at market price. The cost of retained earnings does not include the flotation or sales cost associated with new issues of common or preferred stock. (Block & Hirt, 2005) Debt instruments are requires a fixed payment with interest, examples are bonds, government or corporation and mortgages. Ask Dr Econ, 2008) Bondholders do not gain ownership, paid before other expenses, less risky and not entitle to future profits in the business. (Raymond, 2002). Disadvantages include potential restrictions on operations, limitations on the use of working ca pital (Raymond, 2002). Bond financing includes the zero-coupon rate bond and the floating rate bond. The cost of debt is measured by the after-tax cost of debt and must be calculated as follows Kd = Yield (1 t) where Yield = deliver to maturity and t = tax rateThe yield to maturity of a bond is dependent on a number of variables annual interest payment, leading payment, bond price and years to maturity. The yield to maturity for a bond can be calculated using a bond table, or using the equation below Y = annual interest payment + (principal payment bond price) / years to maturity) (Block & Hirt, 2005) Evaluation of Long-Term Financing Alternatives Organizations have several opportunities foralternative long-term financing to help the organization expand and grow, raise capital depleted by inflation and to supplement insufficient funds generated internally by the organization.Debts for organizations have risen over the past three decades. Organizations are faced with the task of continuing to raise capital to cover the organizations debts. Organizations can use bonds, stocks, leasing and other options as options for long-term financing Bonds Most large organizations use corporate bonds for long-term financing. The bond commensurateness specifies such basic items as the par value, the coupon rate, and the maturity date (Block & Hirt, 2005). The initial value of a bond is the bonds par value or face value. The interest rate on the bond is the coupon rate.The hesitation of interest rates in the market affect the coupon rate of the bond after the bond has been issued. The ending date in which repayment of the principal of the bond is due is the maturity date. The bond agreement or indenture is the legal document that covers the bond from issuance to repayment. Organizations can put up a secured bond offering such as a mortgage agreement, where specific assets are promised to bondholders should they default on the bond or choose an unsecured, or debenture bon d offering which doesnt specify a specific asset. Stocks Common stock is on way an organization can secure long-term equity financing.Common stock is issued at a price per share to relatives, friends and investors. The funds are used by the organization to help the organization grow. The organization can issued to stockholders as dividends to show a payback on the capital investment. The remaining funds after the organization pays out dividends become retained earnings for the organization and are reinvested back into the organization. Individuals who have ownership in the organization can hold preferred stock. Preferred stock holders are repaid first should the organization read for bankruptcy.Leasing Organizations can lease assets instead of financing them. Leasing can give an organization that is short on funds or is not credit worthy profuse to borrow funds a way to obtain assets. Leasing an asset is generally more expensive than purchasing the asset. By leasing assets, the or ganization reduces cash outflow so they can use those funds for other ventures. Organizations can lease assets such as furniture, equipment and land. The organization can choose a Capital Lease agreement where the organization purchases the asset at the end of the lease period.Organizations in a higher tax bracket can take advantage of a dispraise write-off tax advantage by purchasing an asset and leasing the asset to another organization in a lower tax bracket. Other Alternatives Organizations can use Factoring to borrow capital. The factor generally charges higher interest rates than banks. Factors generally review credit history, but the organization may unbosom be able to borrow due to the quality of the organizations collateral rather than their project projections. Conclusion Expanding a company can be a big step and many plans must be laid out and consider before the final decision can be made.Cost is the biggest factor that must be considered when expanding. The second fac tor to consider is who or how the cost is going to be covered. Most companies consider there finance options. Financing option that should be considered include taking on more debt, issuing bonds, and selling stock. With these options the interest rate, the selling price of the stock and how much of the company they would like to give up all must be considered when choosing an option. The better option would be to do a mix of all of the financing options to keep the balance sheet leveled, and the company in good financial standing.References Ask Dr Econ. (2008) Federal Reserve Bank of San FranciscoWhat are the differences between debt and equity markets? Retrieved October 31, 2008 from http//www. frbsf. org/education/activities/drecon/answerxml. cfm? selectedurl=/2005/0510. html Block, S. B. , & Hirt, G. A. , (2005). Foundations of fiscal Management (11th ed. ). New York McGraw-Hill. Capital Asset Pricing Model, (2008). Retrieved October 31, 2008, from http//www. moneychimp. com/g lossary/capm/htm. Capital Asset Pricing Model