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An established company is considering expanding its operations, and to achieve their business objectives, the company will require additional long-term capital financing. Long-term financing involves debt or equity instruments with greater than one-year maturities, and the cost of this long-term capital can be calculated using either the Capital Asset Pricing Model (CAPM) or Discounted Cash Flows (DCF) Model. This report will consider the costs and characteristics of various long-term debt and equity financial instruments, and discuss financial prudent debt/equity ratios. Various dividend and principal repayment policies will also be considered for corporate bonds.
Economist William Sharpe Won the Noble Prize in 1990 for his research on what devolved to be the CAPM theory on estimating the cost of capital for firms and evaluating the performance of managed portfolios. Sharpe "provided much of the basis for what is now termed the Capital Asset Pricing Model (CAPM)" (Frängsmyr, 1991) through a financial model that explains how securities are priced based on their potential risks and returns. "CAPM is a linear relationship between returns on individual stocks and stock market returns over time" (Block & Hirt, 2005, p. 342). Although more than one formula exists for the CAPM, the most common is referred to as the market risk premium model presented below (Block & Hirt, p. 343):
Kj = Rf + β(Km Rf)
Where: Kj = return on company's common stock
Rf = the risk free rate of return (short-term Treasury bill securities),
β = beta coefficient, or historical volatility of common stock relative to market index, and
Km = average market return based on an appropriate market index.
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. The beta coefficient is a measure of stock volatility for the individual firm, relative to an equivalent market indicator of similar stocks. Higher betas mean greater risk. When the risk associated with a particular stock is equal to the market index risk or average risk across multiple stocks, the beta coefficient (β) will equal 1.0, and Km = Kj. 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) are considered fixed, then the required rate of return for company stock can be calculated for the security market line (SML) or 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 β = 1, and 16% for β = 2.
The Discounted Cash Flow (DCF) Model is another "standard way of determining the cost of equity. It assumes that a firm's current stock price is equal to the present (that is, discounted) value of all expected future dividends from the investment" (Utility Regulation, 2006). "Modern financial theory contends that the price of a firm's stock is the present value of the future cash flows discounted at an appropriate interest rate" (Freeman & Gagne, 1992, p. 141). To calculate the current stock value, we must 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 opportunity cost of a forgone investment over the same period, or the weighted average cost of capital (WACC) for the firm. Discounted cash flow equations for various financial instruments are presented in the paragraphs that follow.
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. By definition, CAPM is more objective and complicated, and requires more calculation and data from the market and historical documents. DCF is more subjective and simplified; however, the assumptions required for DCF are sometimes too strong for a specific firm. One such DCF assumption is that future dividends will grow forever at a constant rate (in perpetuity). Since this assumption is not always true, the DCF method gives a more qualitative estimate of the cost of capital.
The cost of capital assessment may include a budgeting process of evaluating projects that require a significant investment of current capital in exchange for a payoff that may not materialize for years (Vance, 2003). Each project must be capable of providing a return on investment equal to or greater than the cost of capital to fund the project. As with any new undertaking or business expansion, the use of long-term financing includes some risk to the corporation. This financial risk increases as the debt portion of the capital structure increases.
Debt-equity mix is a term used to describe the ratio of debt to equity in the capital structure of the firm. Debt and equity financing differ in nature and complement each other. Debt needs to be repaid with interest, and the principal must be paid off at maturity or refinanced. Debt financing does not dilute the stockholder's interest in the company, but carries a financial risk if a downturn in business occurs. Equity financing involves new issues of preferred or common stock, and dilutes the existing stockholder's interest in company earnings and value. "In choosing the right mix of debt and equity, you must consider three issues: your projected cash flow to repay debts, the relative cost of the different types of financing, and the impact of sacrificing some ownership and control" (Strategis, 2006).
The appropriate combination of debt and equity means an optimum capital structure, and the lowest weighted average cost of capital (WACC). The optimum range is dependent on investors' perception of an appropriate level of debt for a particular industry, and generally falls within the 30% to 50% percent range of overall capital structure. Because debt is typically the cheapest form of financing capital, moderate increases in the debt load may reduce the WACC. Beyond some point, however, the additional financial risk to the company and investors drives up the cost of all future debt and equity financing.
Debt financing can take the form of bank loans or new issues of corporate bonds. The corporate bond represents the basic long-term debt instrument for most large corporations (Block & Hirt). The two main considerations involving a bond agreement are the security provisions of the bond, and the methods of repayment. A bond may involve either secured or unsecured debt. The method of bond repayment may involve a serial payment, sinking fund provision, conversion, or call provision. Other forms of bond financing include the zero-coupon rate bond and the floating rate bond (Block & Hirt). "The cost of debt is measured by the interest rate, or yield paid to bondholders"(Block & Hirt, p. 313). Because interest paid on loans and bonds is tax deductible, the after-tax cost of debt must be calculated as follows:
Kd = Yield (1 - T)
Where: Yield = Yield to maturity
T = Corporate tax rate (e.g.: 35%)
The yield to maturity of a bond is dependent on a number of variables including: annual interest payment, principal payment, bond price, and years to maturity. The yield to maturity for a bond can be calculated using a bond table, or approximated using the equation below:
Y' = annual interest payment + [(principal payment bond price)/years to maturity]
0.6(bond price) + 0.4(principal payment)
Common equity financing is another method of obtaining long-term capital. The cost of common equity is extremely important as "the ultimate ownership of the firm resides in common stock" (Block & Hirt, p. 505). The cost of issuing new common stock is expressed as:
Kn= D1/(PoF) + g
Where: D1 = First year common dividend,
P0 = Price of common stock,
F = Flotation (selling) costs
g = Constant growth rate in earnings.
Sale of preferred stock represents another financial instrument involving company equity. Preferred stockholders are promised a stipulated dividend on an annual or semi-annual basis. These dividends must be paid before any common stock dividends can be distributed; however, they are not guaranteed. Some preferred stock includes a cumulative feature, whereby unpaid dividends from prior years accumulates and is paid as funds are available. Unlike bonds, dividend payments to preferred stockholders are not tax deductible to the firm, and no principal payment or maturity date is associated with preferred stock (Block & Hirt). Preferred stockholders have no claim to earnings beyond the stipulated preferred stock dividend (Williams, Haka, Bettner, & Carcello, 2006). The cost of issuing new preferred stock is:
Kp = Dp/(Pp-F)
Where: Dp = Preferred dividend,
Pp = Price of preferred stock,
F = Flotation (selling) costs.
Retained earnings are another form of common equity capital. Retained earnings are equivalent to "past and present earnings of the firm minus previously distributed dividends" (Block & Hirt, p. 318). In order to convince shareholders that earnings diverted now will equal larger dividends and equity later, it is important for the firm to calculate the present value of projected future cash flows. The equation for cost of retained earnings is equivalent to the cost of existing common stock (Ke= D1/Po + g), since retained earnings can be used to reacquire outstanding (treasury) stock at market price. The cost of retained earnings does not include the floatation or sales cost associated with new issues of common or preferred stock.
Another popular way to finance future growth in the business is through long-term or capital leases. Leasing is often limited to items that have a long serviceable life, transferable use, or are easily repossessed and resold in the event of default (University of Wisconsin, 1999). In the long run, leasing is generally more expensive than bank financing. As part of the lease agreement, the business may purchase the leased equipment at the end of the lease period for a predetermined fraction of the original value.
In conclusion, evaluation of long-term financing options is an important part of the decision to expand a business. Available financing options may include the sale of stocks or bonds, reinvestment of retained earnings, or capital leasing. The sale of stocks or bonds raises money capital that can be invested in the business to purchase long-term capital assets. If cash is generated from operations and not distributed to stockholders as dividends, then these retained earnings can be reinvested in business expansion. Similarly, capital leasing can be used in lieu of capital purchases or loans, in order to acquire the plant facilities and equipment necessary for business expansion. Choosing an appropriate mix of debt and equity financing for expansion is critical in order to minimize the weighted average cost of capital (WACC), while moderating financial risks, and maximize stock value and stockholders return on investment.
Block, S.B. & Hirt, G.A. (2005). Foundations of Financial Management (11th ed.). New York: McGraw-Hill.
Freeman, G. R. & Gagne, M. (Fall 1992). An Investigation of the Usefulness of Cash Flows: The Effect of Firm Size. Journal of Applied Business Research. Laramie. 8 (4).
Frängsmyr, T. (1991) Les Prix Nobel ,Stockholm. Retrieved December 9, 2006 from http://nobelprize.org/nobel_prizes/economics/laureates/1990/sharpe-autobio.html
Strategis (2006), Retrieved December 25, 2006 from http://www.strategis.ic.gc.ca
University of Wisconsin (1999). Alternative Financing Sources for Your Small Business Retrieved December 27, 2006, from http://www.uwrf.edu/sbdc/altfinance.html
Utility Regulation (2006), Retrieved December 25, 2006 from http://utilityregulation.com
Vance, David, E. (2003). Financial Analysis and Decision Making: Tools and Techniques to Solve Finical Problems and Make Effective Business Decisions (1st ed.). New York: McGraw-Hill.
Williams, J.R., Haka, S.F., Bettner, M.S. & Carcello, J.V. (2006) Financial Accounting (12th ed.). New York: McGraw-Hill.