Problem Solution Gene One

Long-Term Financing

Long- term financing strategies are used by financial managers to insure that funds invested today will increase in value or stay the same over a stated period of time. This document will compare and contrast the capital asset pricing model (CAPM) and discounted cash flow method (DCF). The debt and equity mix are intended to enable an organization to capitalize on investments. The debt and equity mix will be reviewed as will the characteristics of the financial market and debt and equity instruments. Long-term finance options will be analyzed.

Valuation Models

The Discounted Cash Flows Model (DCFM) and the Capital Asset Pricing Model (CAPM) are examples of estimation tools used to determine present securities values through the time value of money. DFCM uses simple discounting of projected cash flows over the life of the security, while CAPM uses a more complicated formula. Both methods apply to individual securities and help investors to decide investment risk choices; however, CAPM also "turns finding the efficient frontier into a doable task, because you only have to calculate the co-variances of every pair of classes, instead of every pair of everything" (Moneychimp, n.d.). The CAPM thereby gains the investor more information about a wider range of securities than the DCFM provides.

DFCM uses either the internal rate of return (IRR) or the net present value (NPV) method to calculate present values of future cash flows. Both these methods use standard present value tables to calculate present value equivalencies, so they are simple if the proper tools are available. The IRR finds yield, and its formula divides the present value of the investment by the annuity:

(Investment) / (Annuity) = x

Then, find the value of x in the Present Value of an Annuity table (Block & Hirt, 2005, p. 642) to determine the applicable period and percentage. The NPV finds present dollar value of cash flows. NPV uses present value tables to arrive at dollar values for inflows. Outflows deducted from inflows equal the net present value. Comparing NPVs between investments determines which investment is the better choice.

Compared to DFCM's simplicity, CAPM is downright complicated! However, with its deeper analysis comes greater applicability. CAPM uses beta, which is "a measure of an investment's volatility, relative to an appropriate asset class" (Moneychimp, n.d., glossary). The CAPM formula is:

r = Rf + beta (Km - Rf)

which denotes the expected security return rate = risk-free rate (e.g., cash) + beta * (asset class return rate - risk-free rate) (Moneychimp, n.d.). Essentially, the CAPM finds the rate of return like the IRR method under DFCM does. The CAPM also "implies that investing in individual stocks is pointless, because you can duplicate the reward and risk characteristics of any security just by using the right mix of cash with the appropriate asset class" (Moneychimp, n.d.).Debt/Equity Mix

Debt-to-Equity and Dividends

The Debt / Equity mix that companies employ to fund operations or capital expenditures depends on many factors. As the table below shows, the debt ratio of companies can vary greatly. The industry can be an enormous factor. A hotel has large fixed costs, due to the services it provides. Conversely, a company dependent on innovationвЂ" pharmaceuticals, software design вЂ" may desire small returns quickly as opposed to large returns after heavy investment.

Debt as a percentage of total assets (Fall 2003)

Selected Companies with Industry Designation Percent

Mylan Labs (pharmaceuticals) 10%

Liz Claiborne (women's clothing) 22

Microsoft (software) 28

IBM (computers) 48

Borg-Warner (auto parts) 52

Dow Chemical (petrochemicals) 56

Hilton Hotels (lodging) 72

Delta Airlines (air travel) 83

(Block, 2005, p. 39)

The Cost of Debt is the yield to maturity with an allowance made for taxes.

Cost of Debt = Yield (1 вЂ" Tax)

The Valuation Approach is used to calculate the cost of common equity. This approach is used because it takes into account the requirements of present and future stockholders. The Required Rate of Return is calculated. This approach says:

P0 = D1/( K e вЂ" g)

Or: Ke = D1/P0 + g

• P0 = Price of the stock today

• D1 = Dividend at the end of the first year (or period)

• Ke = Required rate of return

• g = Constant growth rate in dividends (Block, 2005, p. 17).

An alternate calculation of the Required Return on Common Stock is

E(Ri) = Rf + Ð"ÑŸi(Rm вЂ" Rf);

whereby E(Ri) is the expected rate of return on an investment, Rf is the rate of return on risk-free asset, Ð"ÑŸi is an investment's beta, and (Rm вЂ" Rf) is the market risk premium. (Reilly, 2005).

The Cost of Retained Earnings is the equivalent of the Cost of Common Stock. This can be the largest source of equity capital. The Dividend policy - sharing of profits with shareholders - affects the amount of retained earnings that are available for reinvestment.

The Cost of New Common Stock makes an allowance for the price of the stocks, so:

(Block, 2005, p.26)

Weighting the sources of capital is done with an eye toward minimum cost of capital. The sources are essentially debt and equity (preferred stock and common stock). The mix of these sources has been calculated to be optimal at a 40% debt to total asset level, but may vary depending on the goals of the company. Due to tax breaks, acquiring debt is initially the cheapest form of financing, but as more debt is incurred, the risk rises and financing gets more expensive.

Debt and

...