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.
The new lift has an economic life of 20 years and we would like to make 14% on our investment. The NPV factor of 14% at 20 years is 6.6231. By multiplying our net yearly income or our annuity of $500,000 times the NPV factor of 6.6231 we will have a NPV of $3,311,550.
The first important component of DCF needs to be estimated is the expected future Free cash flow of the company. However FCF prediction has already been done by Acker. The relevant data is the estimated cash flow from 2002 to 2008, As well as the real FCF at the end of 2001. all figures in this report is in $ value:
The estimates of cost of capital for equity 6.14% are making by using the capital asset pricing model (CAPM) to generate forecast of DDM and RIM. This method is defined by the sum of risk free rate plus beta that multiplied with a risk premium. Particularly, the beta, which is a quantitative measure of the volatility of company stock relative to the unstable of the overall market, found in JB HI-FI case at 0.56 (JB HI-FI financial statement 2016). It
We defined several criteria to determine our choice – return, risks and other quantitative and qualitative factors. Targeting a debt ratio of 40% will maximize the firm’s value. A higher earning’s per share and dividends per share will lead to a higher stock price in the future. Due to leveraging, return on equity is higher because debt is the major source of financing capital expenditures. To maintain the 40% debt ratio, no equity issues will be declared until 1985. DuPont will be financing the needed funds by debt. For 1986 onwards, minimum equity funds will be issued. It will be timed to take advantage of favorable market condition. The rest of the financing required will be acquired by issuing debt.
We can rationalize not using DCF for its inability to capture risk uncertainty. Passive investments such as stocks and bonds are good candidates to use DCF on. Once these investments are made, investors cannot influence the cash flow generation. We agree that decision tree can be used to make preliminary judgments and real option analysis can be used to get more definitive answers. We think that sensitivity analysis and scenario analysis could be useful since all inputs may change over time.
Discounted Cash Flow Method takes the forecast free cash flows during forecasted horizon. Then we estimate the cost of capital (weighted average cost of capital) and estimate continuing value (value after forecast horizon). The future value is discounted to the present value. We than add back cash ($13 Million) and non-current assets and deduct total debt. With the information provided several assumptions had to be made to obtain reasonable values (life period of 30-years, Capital expenditures not to exceed $1 million dollars, depreciation to stay constant at $1.15 Million and a discounted rate of 10%). Based on our analysis, the company has a stand-alone value of $51 Million at the end of fiscal year end 1990 with a net present value of cash flows of $33 million that does not include the cash and non-current assets a cash of and non-current assets.
Discounted cash flow is a valuation technique that discounts projected cash inflows and outflows to evaluate the potential value of an investment. There are three discounted cash flow methods: Net Present Value (NPV), Profitability Index (PI) and Internal Rate of Return (IRR). The net present value discounts all cash inflows and outflows at a minimum rate of return, which is usually the cost of capital. The profitability index refers to the ratio of the present value of cash inflow to the present value of cash outflows. The internal rate of return refers to the interest rate that discounts cash inflow projections to the present to ensure that the present value of cash inflows is equivalent to the present value of cash outflows (Brown, 1992).
When discussing the cost of equity capital, or the rate of return required by investors for their share expenses, there are three main models widely used for analyzation. These models are the dividend growth model, which operates on the variable of growth and future trends, the capital asset pricing model (CAPM), which operates on the premise that higher returns are a result of higher risk, and the arbitrage pricing theory (APT), which has a more flexible set of criteria than CAPM and takes advantage of mispriced securities
Berk, J., & DeMarzo, P. (2011). Corporate finance: The core, second edition. (2nd ed.). Boston, MA: Prentice Hall.
Capital Asset Pricing Model (CAPM) is an ex ante concept, which is built on the portfolio theory established by Markowitz (Bhatnagar and Ramlogan 2012). It enhances the understanding of elements of asset prices, specifically the linear relationship between risk and expected return (Perold 2004). The direct correlation between risk and return is well defined by the security market line (SML), where market risk of an asset is associated with the return and risk of the market along with the risk free rate to estimate expected return on an asset (Watson and Head 1998 cited in Laubscher 2002).
Brealey, Richard A., Marcus, Alan J., Myers, Stewart C. 1999, Fundamentals of Corporate Finance, 2nd edn, Craig S. Beytien, USA.
In order to decide on an investment decision regarding the mutual fund she managed, Ford decided to develop her own discounted cash flow forecast.
Today financial corporate managers are continually asking, “What will today’s investment look like for the future health of the company? Should financial decisions be put on hold until the markets become stronger? Is it more profitable to act now to better position the company’s market share?” These are all questions that could be clearly answered if the managers had a magical financial crystal ball. In lieu of the crystal ball, managers have a way of calculating the financial risks with some certainty to better predict positive financial investment outcomes through the discounted cash flow valuation (DCF). DCF valuation is a realistic approach, a tool used, to “determine the future and present value of investments with multiple cash flows” over a particular period of time which is incurred at the end of each period (Ross, Westerfield, & Jordan, 2011). Solutions Matrix defines DCF as a “cash flow summary adjusted so as to reflect the time value of money (The Meaning of Discounted Cash Flow, 2014).” The valuation of money paid or rec...
The capital structure of a firm is the way in which it decides to finance its operations from various funds, comprising debt, such as bonds and outstanding loans, and equity, including stock and retained earnings. In the long term, firms seek to find the optimal debt-equity ratio. This essay will explore the advantages and disadvantages of different capital structure mixes, and consider whether this has any relevance to firm value in theory and in reality.
The Modern portfolio theory {MPT}, "proposes how rational investors will use diversification to optimize their portfolios, and how an asset should be priced given its risk relative to the market as a whole. The basic concepts of the theory are the efficient frontier, Capital Asset Pricing Model and beta coefficient, the Capital Market Line and the Securities Market Line. MPT models the return of an asset as a random variable and a portfolio as a weighted combination of assets; the return of a portfolio is thus also a random variable and consequently has an expected value and a variance.