Long-Term Capital Financing

7/29/2019 Long-Term Capital Financing

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LONG-TERM

CAPITALMANAGEMENT


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Dr. Mazila Md Yusuf Long-term Financing 2

Introduction

LT Capital Management refers to themanagement of firms long terminvestments (assets) and the sourcesof funding or financing these

investments (assets) Long term investment also known as

capital budgeting

Long term sources of financing thecapital budgeting is called long termcapital


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Long-term Capital

Long-term capital is sources offinancing to fund companys long-term investments or fixed assets.

The term capital denotes the long-term funds of a firm.

There are two types of capital:

debt capital and

equity capital.


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The Firms Capital Structure


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Sources of Long-TermFinancing/Capital

1. Equity Financing:

a. Common Stock

b. Preferred/PreferenceStock

2. Debt/Bonds Financing


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Differences BetweenDebt and Equity Capital

The key differences between debtand equity:

1. Voice in Management

2. Claims on income and assets

3. Maturity

4. Tax treatment


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1. Voice in Management

Debt

creditors to the firm

no voting rights,

only when firmviolated its statedcontractualobligations to them.

Equity

owners of the firm

voting rights to

select the board ofdirectors

voting on specialissues.


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2. Claims on Income andAssets

Debt

first claims onfirms income

first claims onproceeds of sale ofassets if firm fails

Equity

last claims onincome i.e. after of

all creditors havebeen satisfied

last claims onproceeds of sale ofassets if firm fails


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3. Maturity

Debt

has fixed maturityperiod

require repaymentof principal onmaturity

Equity

permanent form offinancing

does not requirerepayment ofprincipal

liquidated only

during bankruptcyproceedings.


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4. Tax Treatment

Debt

interest paymentsare tax-deductible

tax deductionexpenses will lowerthe firms taxes

thus, cost of debt

financing is lower

Equity

dividends paymentsare not tax-deductible

thus, firms taxes arenot lower

therefore, cost ofequity financing is

higher


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1. Equity Financing

Equities are sold (issued) by acompany either:

1. at the formation of the company

2. when additional financing areneeded.

Equities are issued in the Primary

Market by the company and resoldby the Equities holders in theSecondary Market.


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A. Common Stock

Features of Common Stock

represents ownership, the holders arethe true owner of the company

no maturity date, but exists as long asthe company does

stockholders have the residual claim on

the firms income and assets


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Features of CommonStock (cont)

stockholders receive variable returns inthe form of dividends

stockholders have pre-emptive rights to

buy any new issued stocks stockholders have the right to vote for

the Board of Directors

stockholders have unlimited, limitedliabilities


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B. Preferred/PreferenceStock

Features of Preferred Stock

a hybrid of common stock and bond.

has no maturity date

has a par value of usually RM100 pershare

stockholders receive fixed amount of

dividends every year


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Features of PreferredStock (cont)

stockholders have no voting rights

stockholders get claims on profits andassets after bondholders but before

common stockholders sometimes carry special features such

as callable, cumulative, participativeand convertibility.


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2. Debt/Bonds Financing

Features of Debt/Bondsdebt/bond is a long-term debt

instrument issued by a firm

holders are promised a fixed amount ofinterest every year until maturity period

interest rate also known as coupon rateand thus interest amount is calculatedas the coupon rate percentage of thepar value

par value or face value of bond isnormally RM 1000


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Features of Debt/Bonds(cont)

maturity period is between 10 to 30years

issuer (firm) also pays the holdersprincipal payment (par value) atmaturity period

holders are considered as creditors tofirm

holders have no voting rightsholders have the first claims on profits

and assets of firm.


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Cost of Long-Term Capital

Each specific sources has specific method tocalculate its cost

The cost must always be stated on an after-tax basis because the cost of financing to thefirm is a return to the providers of the capitaland providers will get their returns only afterfirm pays taxes.

Apart from cost of paying providers of funds,firm also incurred flotation costs total costsof selling and issuing securities


1 Th C t f C St k


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1. The Cost of Common StockEquity

Two different ways to estimate the cost ofcommon equity:

1. any form of the dividend valuation model

2. the capital asset pricing model (CAPM). The dividend valuation models are based on the

premise that the value of a share of stock isbased on the present value of all future

dividends.

Th C t f C St k


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The Cost of Common StockEquity (cont.)

Constant growth (Gordon) model:

Where = cost of common stock = expected dividend

= market price of stock

= constant growth individend


Th C f C S k


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ks = D1/P0 + g

For example, assume a firm has just paid a dividend of$2.50 per share, expects dividends to grow at 10%

indefinitely, and is currently selling for $50.00 per share.

First, D1 = $2.50(1+.10) = $2.75, and

kS = ($2.75/$50.00) + .10 = 15.5%.

The Cost of Common Stock(cont.)

Using Constant Dividend Growth Model


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CAPM Model:

Where = risk free return

= beta coefficient

= market return Note: market return risk free

return = market risk premium



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ks = rF + b(kM - RF).

For example, if the 3-month T-bill rate is currently 5.0%,

the market risk premium is 9%, and the firms beta is

1.20, the firms cost of retained earnings will be:

ks = 5.0% + 1.2 (9.0%) = 15.8%.

Using CAPM Approach



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The CAPM differs from dividend valuationmodels in that it explicitly considers thefirms risk as reflected in beta.

On the other hand, the dividend valuationmodel does not explicitly consider risk.

Dividend valuation models use the market

price (P0) as a reflection of the expectedrisk-return preference of investors in themarketplace.


The Cost of Common Stock


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Although both are theoretically equivalent,dividend valuation models are oftenpreferred because the data required aremore readily available.

The two methods also differ in that thedividend valuation models (unlike theCAPM) can easily be adjusted for flotationcosts when estimating the cost of new

equity.


Th C t f C St k


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Cost of Retained Earnings (kE)- Cost of retained earnings to the firmis the same as the cost of an

equivalent fully subscribed issue ofadditional common stock

- it means cost of retained earnings

equal to cost of common stock equity-


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Cost of New Equity (kn)

Using Constant Dividend Growth Model


Continuing with the previous example, how much wouldit cost the firm to raise new equity if flotation costs

amount to $4.00 per share?

= [$2.75/($50.00 - $4.00)] + .10 = 15.97 %


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Dr. Mazila Md Yusuf Long-term Financing

Duchess Corporation is contemplating the issuance of a

10% preferred stock that is expected to sell for its $87-per

share value. The cost of issuing and selling the stock is

expected to be $5 per share. The dividend is $8.70 (10%

x $87). The net proceeds price (Np) is $82 ($87 - $5).

KP = DP/Np = $8.70/$82 = 10.6%

2. The Cost of Preferred Stock

Note: Net Proceed = Market Price Flotation Cost


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Since the cost must be on after-tax costs, thecost of bonds/debt must first calculate theBefore-Tax Cost of Bonds/Debt

The before-tax cost of debt can be calculatedin any one of three ways:

1. Using cost quotations

2. Calculating the cost

3. Approximating the cost

3. The Cost of Long-TermDebt/Bond (cont.)

Th C f L T


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Before-Tax Cost of Debt

1. Using Cost Quotations; that is basedthe cost on: a.) our quotation of cost or

b.) cost of similar risk bond

a. When the net proceeds (MP FC) from

the sale of a bond equal its par value,the before-tax cost equals the couponinterest rate.

The Cost of Long-TermDebt/Bond (cont.)

h C f


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b. A second cost quotation that issometimes used is the yield-to-maturity (YTM) on a similar risk bond.



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Before-Tax Cost of Debt2. Calculating the Cost

This approach finds the before-tax cost

of debt by calculating the internal rateof return (IRR), i.e. the actual costs tothe firm for having the bonds financing

IRR can be calculated using: (a) trial

and error, (b) a financial calculator, or(c) a spreadsheet.


The Cost of Long Term


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Before-Tax Cost of DebtApproximating the Cost using an

equation




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Example :Duchess Corporation, a major hardwaremanufacturer, is contemplating selling$10 million worth of 20-year, 9% couponbonds with a par value of $1000. Becausecurrent market interest rates are greaterthan 9%, the firm must sell the bonds at

$980. Flotation cost are 2% or $20. Thenet proceeds to the firm for each bond istherefore $960 ($980 - $20).




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Before-Tax Cost of DebtApproximating the Cost


Th C t f L T


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The after-tax cost of bonds/debt:

Find the after-tax cost of debt for Duchessassuming it has a 40% tax rate:

= 9.4% (1-.40) = 5.6%

This suggests that the after-tax cost of raisingdebt capital for Duchess is 5.6%.


W i ht d A C t


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Weighted Average Costof Capital(WACC)

When firm has a mixture of capital asthe sources of its LT financing, howmuch would its overall cost of capital

be?

The overall cost is known asweighted average cost of capital

(WACC) Why?


Th W i ht d A C t


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The Weighted Average Costof Capital (cont)

WACC reflects the expected averagefuture cost of funds over the long-run

WACC is found by weighting the cost of

each specific type of capital by itsproportion in the firms capitalstructure.

In equation, WACC can be written as:


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WACC Equation

where = proportion of long-term debt in

capital structure = proportion of preferred stock in

capital structure

= proportion of common stockequity in capital structure

= 1.0

)*()*()*( ccppiia kwkwkwk

iw

pw

cw

cpiwww


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The Weighted Average Cost ofCapital (cont)

Determine Capital Structure Weights

One method uses book valuesfrom the firms balance

sheet. For example, to estimate the weight for debt,

simply divide the book value of the firms long-term debt

by the book value of its total assets.

To estimate the weight for equity, simply divide the total

book value of equity by the book value of total assets.

f


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A second method uses the market valuesof the firms debt

and equity. To find the market value proportion of debt,

simply multiply the price of the firms bonds by the numberoutstanding. This is equal to the total market value of the

firms debt.

Next, perform the same computation for the firms equity

by multiplying the price per share by the total number of

shares outstanding.


Capital Structure Weights

h h d f


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Finally, add together the total market value of the firms

equity to the total market value of the firms debt. Thisyields the total market value of the firms assets.

To estimate the market value weights, simply divide the

market value of either debt or equity by the market value

of the firms assets .

h i h d C f


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Dr. Mazila Md YusufLong-term Financing

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For example, assume the market value of the firms debt is $40

million, the market value of the firms preferred stock is $10million, and the market value of the firms equity is $50 million.

Dividing each component by the total of $100 million gives us

market value weights of 40% debt, 10% preferred, and 50%common.

Th W i h d A C f


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Dr. Mazila Md Yusuf 44



Using the costs previously calculated along with the

market value weights, we may calculate the weighted

average cost of capital as follows:

WACC = .40(5.6%) + .10(10.6%) + .50(15.8%)

= 11.2%

This assumes the firm has sufficient retained earnings tofund any anticipated investment projects.

Long-Term Capital Financing

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