Long Term Financing 1

Running head: Long Term Financing Paper

Long term Financing Paper

Jo Ann Collier

Alessandra Guglielmi

Scott Kurz

Rosanne Peterson

Charles Shankar

University of Phoenix
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Introduction

There are many reasons why a company may require long term financing, such as if a

failing company is confident that it will recover its loss by the next fiscal year, a growing

company that needs financing to expand its business, working capital required to meet the

customers’ huge order, etc.

Long term financing is normally desired by company running low on their capital

deficit business fund. The term of finance is more than a year, and depending on the type of

the company, non-Corporations are limited to using debt finance while Corporations can use

both debt and equity products in their long term financing strategies.

Various types of long term debt product are as follows:

• Debentures
• Secured and unsecured notes
• Convertible notes
• Fixed deposit loans
• Mortgages
• Eurobonds
• Interest rates swaps
• Forward rate agreements (FRA’s)
• Interest only futures
• Option on future contracts.
• Convertible notes
• Subordinated debt
• Preference shares

In order to fully understand this subject, we have to look at various models,

policies, and instruments as well as alternatives available in the market for the company to

progress to meets its ultimate goal of making money for herself and her stockholders.
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Capital Asset Pricing Model and the Discounted Cash Flows Model

It makes good sense for any company that engages in various investment opportunities to

consider utilizing the (CAPM) Capital asset pricing model in order to adequately assess

investment risk. When using the CAPM companies can be expected to get some idea of an

individual asset’s value of worth. The CAPM will assist a company in determining the expected

rate of return and, if anticipated cash flows can be determined, the price of the asset can be

estimated.

The CAPM has a symbiotic relationship with the discounted cash flows. Once a

company’s expected rate of return is determined from the CAPM, a discount can be applied to

the anticipated future cash flows of the investment, using that particular rate, this will aid in

establishing the right price for an asset. In other words, the price of an asset is directly correlated

with value calculated through the CAPM discounted rate. The CAPM and the discounted cash

flows should be parallel in nature, the direction of change, whether positive or negative will be

similar in both areas.

The CAPM returns the discounted rates, which is the rate at which future cash flows

earned by a particular asset based on that assets level of risk. When using the CAPM, a company

should expect rate of return to be consistent with the risk. For example, the higher the risk, the

higher the return and the same applies to less risky investments.

While there are many advantages to using the CAPM, there also exist many

shortcomings. For example, the model does not allow for investors who will accept lower

returns for higher risk, does not adequately explain the variation in stock returns, assumes there

are no taxes or transaction cost, and fails to include all types of assets (http://en.wikipedia.org).
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A company has to ensure that it weighs all the pros and cons of the various asset valuation

models, for they all have their negative and positive aspects, it would possibly be wise to take an

ecumenical approach when evaluating these different investment models, by attempting to

incorporate a small segment of each.

Debt/Equity Mix and Dividend Policy

To determine the appropriate debt/equity mix, one must understand the differences

between debt and equity financing. The best financial mix is what will give the best returns to

the investors. The decision to pay dividends or to raise or lower stock and bond prices will all be

determined by the debt load and the cash flow of the firm (Dynamic equity, 2007). A debt is any

interest-bearing liability, whether short term or long term as well as any lease obligation, whether

operating or capital (Domodaran, A., 2007).

The differences between debt and equity are as follows:

Debt:

• Must be repaid or refinanced

• Requires regular interest payments; companies must generate

cash flow to pay

• Collateral assets must usually be available

• Debt providers are conservative; they want to eliminate all

possible loss or downside risks

• Interest payments are tax deductible

• Debt has little or no impact on control of the company

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• Debt allows leverage of company profits

• Failure to make payments can lead to either default or loss of

control of the firm to the party to whom payments are due

• Adds discipline to management

• Loss of future flexibility

Equity:

• Can usually be kept permanently

• No payments requirements and may receive dividends, but only

out of retained earnings.

• No collateral required

• Equity providers are aggressive and accept risks

• Dividend payments are not tax deductible

• Equity requires shared control of the company and may impose

restrictions

• Shareholders share the company profits(Dynamic equity, 2007).

“Equity investment is like investing with free money, without interest or repayment”, (Dynamic

equity, p.2). However, if the after-tax cost of debt is lower than the company’s net return on

assts, the company should take on as much debt as it can. This is known as leverage. If profit

margins are higher than net interest rates it can maximize the return on equity by minimizing

equity and maximizing debt. If not, then the exact opposite is done. If the company cannot
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afford to pay debt, then management needs to finance through equity. “Equity is also a cushion;

debt is a sword,” (Damodaran, p.12); management who have high cash flows left at the end of

the year may be more likely to spend on poorly projects or capital decisions because of

complacency. Firms return cash to stockholders through equity repurchases or dividends.

Dividends are usually paid to the stockholders on a quarterly, semi-annual or annual basis.

Firms, however, with great investment opportunities do not usually pay, or pay the lowest,

dividends in as both percent of earnings (payout ratio) and as a percent of price (dividend yields),

but stable firms with larger cash flows and fewer projects tend to pay more of their earnings out

as dividends (Dividend policy, Ch. 10).

Dividends are a constant portion of earnings per share and a firm that is stuck to its

payout ratio would have to change its dividend whenever earnings changed. Some companies

prefer a steady progression in dividends and some more conservative companies payout only a

portion of their targeted payment ratio. The more conservative the company, the more slowly it

would move toward its targeted ratio and the lower its adjustment rate for dividend payout

(Harvey, C., 1995).

Investments into companies usually require both debt and equity. The optimal ratio will

depend on the needs of the company, is situational and will almost never be 100% equity. If the

long-term prospects are so poor for equity investment, then the company can never have

sufficient profits to benefit from leverage and debt is a better option. Relying on 100% debt

places a large drain on cash flow and can lead to sub-optimal growth. Debt and equity financing

should be considered to complement each other and not as substitutes for each other. Debts need

to be repaid with cash and equity needs to be rewarded with long-term profits as dividends

(Dyanmic equity, 2007). Once debt is outstanding, shareholders have the incentive to take
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actions that benefit themselves at the expense of the bondholders. A conflict that can occur

between stockholders and bond holders because of debt would be claim dilution (increasing the

risk of the “old debt” where its market value falls and making the claim for the new debt equal or

higher priority). Bondholders are concerned about expected cash flows and debt pricing.

Debt and Equity Instruments

In order to raise money in order to finance a business operation, a firm generally has a

choice between debt instruments and equity instruments. There are pros and cons related to each

of these options. In order to differentiate between these two types of financing instruments, a

discussion of the characteristics of each instrument is presented here.

A debt instrument is an obligation that enables the issuing party to raise funds

by promising to repay a lender in accordance with terms of a contract. Types of debt instruments

include notes, bonds, certificates, mortgages, leases or other agreements between a lender and a

borrower. Most companies can borrow from banks, but view direct borrowing from a bank as

more restrictive and expensive than selling debt on the open market via a bond issue. For a

company such as yours, the primary debt instruments used would be notes and bonds. Notes and

bonds are securities that have a stated interest rate that is paid semi-annually until maturity. What

make notes and bonds different are the terms to maturity. Notes are usually issued in terms of

less than ten years. Conversely, bonds are long-term investments with terms of more than 10

years.

An equity instrument is a type of security that signifies ownership in a corporation and

represents a claim on part of the corporation's assets and earnings. Equity instruments normally
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take the form of stock. There are two main types of stock: common and preferred. Common

stock usually entitles the owner to vote at shareholders' meetings and to receive dividends.

Preferred stock generally does not have voting rights, but has a higher claim on assets and

earnings than the common shares. For example, owners of preferred stock receive dividends

before common shareholders and have priority in the event that a company goes bankrupt and is

liquidated.

It is not clear cut as to which type of instrument is the most beneficial for a

company. Too much debt can create too much fixed expense in the form of interest owed to the

bond and note holders. Too much equity has the effect of diluting the ownership stake of each of

the stockholders. Companies are never certain what their earnings will amount to in the future,

and the more uncertain their future earnings, the more risk presented. Thus, companies in very

stable industries with consistent cash flows generally make heavier use of debt than companies in

risky industries or companies who are very small and just beginning operations. New businesses

with high uncertainty may have a difficult time obtaining debt financing, and thus finance their

operations largely through equity.

Long-term Financing Alternatives

Long-term financing alternatives are necessary for business development. This generally

refers to financing with a maturity of more than five years, and is used to finance long-lived

assets, such as land and development, or construction projects (Shim & Siegel, 2000). There are

several options for companies to consider, including selling of stock and bonds, leases, and more.

The money that is needed will have to come from debt or equity financing. Debt financing
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means that a loan is taken out, while equity financing is a way of selling off a portion of your

company to investors in order to raise the money that is needed (willitfly.com).

The first type long term financing that will be discussed is a bond. This is a type of debt

financing. A company that is looking to borrow money could issue bonds. Money would be lent

to the company by those who purchase the bonds. In return, the company would pay a specified

interest rate over the life of the bond, followed by a repayment of the principal when the bond

reaches maturity (investinginbonds.com). Some advantages to issuing bonds include that the

interest payments for bonds are tax deductible, and interest rates may be lower than bank loans

(etrade.com). Disadvantages could include potential restrictions on operations, and limitations

on the use of working capital due to debt obligations (tenonline.org). These disadvantages could

apply to all types of debt financing, as obligations to pay back money can restrict the different

ways that a company’s money can be put to work for them.

Issuing stocks (both common and preferred) is a form of equity financing. These also

have advantages and disadvantages that should be considered by a company. “Issuance of stock

would increase the total number of outstanding shares which would result in a dilution of

ownership and a corresponding reduction in value” (etrade.com). Issuing stock is still a common

tactic used in long-term financing. “It represents an ownership in a corporation, including an

interest in earnings, that translate into declared dividends, as well as an interest in assets

distributed upon dissolution” (tenonline.org). Advantages to issuing stock include that there is

no obligation to repay the amount invested, and there is no obligation to pay dividends, which

allows earnings to be reinvested in the company (tenonline.org).

Preferred stock is another form of equity financing, but also has certain characteristics of

debt financing. With preferred stock, there is no dilution of management’s interest in corporate
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growth or voting power (if non-voting preferred stock is issued), while at the same time pre-

established dividend payments must be made (tenonline.org).

Leasing is one more form of debt financing. A capital lease is when all the benefits and

risks of ownership of the asset that is being leased are transferred to the lessee. In this type of

lease, the property may transfer ownership to the lessee at the end of the lease term, or it could

have a bargain purchase price at the end of the lease (Block & Hirt, 2005). Advantages to

leasing include that it helps companies obtain the use of property that lack funds to purchase the

asset, and there may be no down payment requirement. An obvious disadvantage is that the

company does not own the asset.

Conclusion

Two very useful business tools to access risk management are the capital asset pricing

model and the discounted cash flow model. The best mix of debt/equity will provide the investor

with the best returns. A clear understanding of the definition of debt, equity and dividends will

definitely be a plus to anyone wanting to start a business.

Debt instruments such as notes, bonds, certificates, mortgages, leases or other agreements

between a lender and a borrower are used to obtain long term finance to sustain a business

operation. Bond is another alternative to debt financing. People who purchased bond will be paid

a specific interest during the term that they possessed the bond. Common and preferred stock are

equity financing. Leasing, another form of debt financing, allows the lessee to use the property

without buying it and usually useful for the company that do not have fund even for the down

payment.
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References

Block, S.B., & Hirt, G.A. (2005). Foundations of financial management. New York: The
McGraw-Hill Companies.

Damodaran, A. (2007). The debt-equity trade-off: The capital structure decision.

Retrieved May 4, 2007, from http://www.stern.nyu.edu

Debt vs. Equity. (2007). Retrieved May 4, 2007, from http://dyanmic-equity.com

Dividend Policy. (2007). Retrieved May 4, 2007, from http:// www.studyfinance.com

Harvey, C. (December, 1995). Capitol structure and payout policies. Retrieved May 5, 2007,
from http://www.duke.edu

Ross Thompson Christensen Westerfield Jordan, 'Fundamentals of Corporate Finance', 2nd

edition, 2001 , 502-534

Shim, J.K., & Siegel, J.G. (2000). Financial management. New York: Barron’s Educational
Series, Inc.

Website: http://www.investinginbonds.com/learnmore.asp?catid=46&id=2 Retrieved May 3,

2007.

Website: http://www.tenonline.org/art/sl/9207.html Retrieved May 3, 2007.

Website: http://www.investopedia.com Retrieved May 4, 2007

Website: http://en.wikipedia.org Retrieved May 5, 2007