Long Term Financing Paper Final

Running head long Financing Long-Term Financing University of Phoenix Online Introduction to Finance and explanation MMPBL-503 James R. Sullivan November 3, 2008 Long-Term Financing An established follow is count oning expanding its operations, and to achieve their melodic phrase objectives, the company bequeath require additional long-run enceinte financial backing. long-run financing involves debt or fair-mindedness instruments with great than maven-year maturities, and the bell of this long-term capital provide be cipher using either the chapiter summation determine (CAPM) or Discounted immediate comprisement Flows (DCFM) Model.The ecesis will move over to comp be and contrast the majuscule Asset Pricing Model with the Discounted capital Flows Model. The skill of comparing and contrasting financial options will assist appraise and organize the debt/ rectitude ruffle up and divid decision insurance policy. The brass must then find out what type of l ong-term finance alternatives will most likely benefit. Capital Asset Pricing Model and the Discounted Cash Flows Model Capital Asset Pricing Model is a linear relationship between harvest-feasts on individual line of descents and tenor commercialize returns over time (Block & Hirt, 2005).One use of CAPM is to analyze the performance of mutual funds and opposite portfolios (CAPM, 2008). Although, more than one formula exists for the CAPM, the most assignting green is referred to as the food market put on the line amplitude model presented downstairs (Block & Hirt, 2005) r = Rf + of import (Km Rf) Where r is the judge return deem on a earnest Rf = the riskiness cede tread of return ( coin)B = beta coefficient, or historical irritability of parking lot linage relative to market index Km = is the return rate of the appropriate summation class The market risk premium formula assumes that the rate of return or premium demanded by investors is directly proporti onal to the perceived risk associated with the green assembly line. Beta measures the volatility of the security relative to the asset class. The equation is saying that investors require high levels of expected returns to compensate them for higher expected risk.This formula tail assembly 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 foster of (r) that investors expect it to realise (see graph below) (CAPM, 2008). pic More volatile stocks will adjudge a beta coefficient greater than 1. 0, whereas less volatile stocks will give way 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 slew 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 wo o 10% for B = 1 and 16% for B = 2. The Discounted Cash Flow Model (DCFM) is a nonher standard way of determining the monetary judge of equity. It assumes that a theaters current stock price is mate to the present (discounted) comfort of all expected future day dividends from the investment (Utility Regulation, 2008). advanced(a) financial theory contends that the price of a firms stock is the present value of the future cash flows discounted at an appropriate kindle 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 many an(prenominal) future date. The discount rate used for this present value numeration is the weighted average live 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 weighing an d data from the market. DCF is more subjective and simplified.One such DCF guess is that future dividends will grow forever at a constant rate. Since this assumption is not always true, the DCF method gives a more qualitative hazard 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. Input uncertainty, is an different 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 send (DCFM, 2008).Debt/ lawfulness Mix Debt/equity mix is a financing schema used by companies to help fund the business or other investments. Most companies use a combination of both in tell to ensure stability and to keep long-term cost down. Debt is the borrowing of cash from other lenders such as finance companies and banks. Corporate debt has join ond dramatica lly in the last three decades. (Block & Hirt, pg. 468) Other forms of debt include issuing bonds and leasing. Debt has release a common item on balance sheet for many companies, including those just commencement 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 stock realizeers in a company causes the loss of primary ownership and maybe the loss of the reason the company was created. Equity is another form of financing. Equity is also used by outstanding 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 permit become involved.On the other pass the borrower in an equity finance loan has flexibility on quittance terms and the form of fallment (ie. cash, stock , bonds or services). However, most major confederacys have a mixture of debt and equity with making sure they do not have to much leverage in either one. The formula for tally out what a companys debt-equity ratio is (Block & Hirt) Debt/Equity proportion = Total Liabilities Shareholders Equity Dividend Policy A companys dividend policy is up to the company and the profits that are make. If the company is just starting out they may not want to pay dividends to their stockholders.A descent company may want to reinvest any salary 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, concerns premier consideration 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 va lue of their investment at relinquishment time.If expanding a business the dividends that are usually sent out will possibly be lower to help cover the cost of expanding. The expansion may also cause the dividends to increase. virtually investors care about he future earnings and the increase that may occur because of the expansion and earnings increase. Characteristics and Costs 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. Ask Dr Econ, 2008) parkland stock is a form of equity instruments, reinforcements are the common stockholders will share in the companys profitability, does not have to repay investment, dividends, and the votes lot influence management. The disadvantages of common stock, the vote may dilute the managements interest in the corporations growth, and the non-managemen t 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) preferable 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 extent 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 combining weight to past and present earnings of the firm negatively charged 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 project future cash flow. The equation for cost of retained earnings is equivalent to the cost of existing 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 expe nses, 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 capital (Raymond, 2002). Bond financing includes the zero-coupon rate bond and the floating rate bond. The cost of debt is measured by the later on-tax cost of debt and must be calculated as follows Kd = Yield (1 t) where Yield = yield to maturity and t = tax rateThe yield to maturity of a bond is dependent on a number of variables annual interest payment, principal payment, bond price and age 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) valuation 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 a nd to supplement insufficient funds generated internally by the organization.Debts for organizations have risen over the past three decades. Organizations are faced with the depute 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 agreement specifies such staple fibre 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 variance of interest rates in the market affect the coupon rate of the bond after the bond has been issued. The ending date in which quittance 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 bond offering which doesnt trammel 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 destine 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 bear down 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 meritorious enough to borrow funds a way to obtain assets. Leasing an asset is by and large more expensive than purchasing the asset. By leasing assets, the organization 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 depreciation 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 cypher to borrow capital. The factor generally charges higher interest rates than banks. Factors generally review credit history, but the organization may still be able to borrow due to the quality of the organizations corroborative rather than their project projections. Conclusion Expanding a company can be a big step and many plans must be located out and consider before the final decision can be made.Cost is the biggest factor that must be considered when expanding. The second factor 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. htm l Block, S. B. , & Hirt, G. A. , (2005). Foundations of Financial Management (11th ed. ). bracing York McGraw-Hill. Capital Asset Pricing Model, (2008). Retrieved October 31, 2008, from http//www. moneychimp. com/glossary/capm/htm. Capital Asset Pricing Model