Long Term Fiancing

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Recommended: Strength and weakness of CAPM

Introduction

Long-term financing strategies help ensure that the money invested today will earn more than or equal to the amount invested. The capital asset pricing model (CAPM) and discounted cash flow method (DCF) will be compared. The debt and equity mix help a company optimize its wealth. The debt and equity mix will be examined along with characteristics of the financial market, and debt and equity instruments. Finally, long-term finance alternatives such as stocks, bonds, and leases are discussed.

Capital asset pricing model vs. discounted cash flow method

Two methods can be used to calculate the required return on common stock. The first method is capital asset pricing model, or CAPM. In CAPM, the required return on common stock is reached by adding the risk-free rate of return to historical validity of the return. The historical validity of the return is calculated by subtracting the return in the market from the risk-free rate of return.

The discounted cash flow method, or DCF, "uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment," (Investopedia, 2007). A good opportunity exists when the potential for investment is greater than the current cost. The DCF method is used to account for the time value of money, this means the value of a dollar today has a lesser value in the future, all else being equal. The following chart shows how the two methods are calculated and what drawbacks may exist.

Description Formula Drawbacks

Capital Asset Pricing Model (CAPM) "CAPM relates the risk-return trade-offs of individual assets to market returns," (Block & Hirt, 2005). Kj =  + Km + e

• Kj = Return on individual common stock of a company

•  = Alpha, the intercept on the y-axis

•  = Beta, the coefficient

• Km = Return on the stock market (an index of stock returns is used, usually the Standard & Poor's 500 Index)

• e = Error term of the regression equation

CAPM does not measure all types of assets easily.

Discounted Cash Flow Method (DCF) DCF uses future cash flow and discounts it to get the present value. CF1 CF2 CFn

DCF = -------- + -------- + …------

(1 + r)1 (1 + r)2 (1 + r)n

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