Long-Term Financing

Long-Term Financing

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.