Mba/503 Long Term Financing

Introduction

Long-Term Financing is used by corporations and companies to finance projects or to create a cash-flow for current business expenses. Savvy business owners consider the costs of long-term financing before taking on more debt. Additionally, more and more businesses take advantage of an investment strategy to ensure a flow of income in the future. The paragraphs below will discuss these long-term financing models as well as other financial strategies a firm may consider when contemplating future income or debt.

Costs of Debt

The cost of debt is measured by the interest rate, or yield, paid to the bondholders. The cost of debt computation may be difficult if the bond is priced at a discount or premium from par value. To determine the likely cost of the new debt in the marketplace, the firm will compute the yield on its currently outstanding debt. This is the rate that investors are demanding today. To find the current yield to maturity on the debt, the trial and error process can be used. This is where the discount rates are experimented until the rate that would equate the current bond price with corresponding interest payments for certain years and maturity payments are determined (Block & Hirt, 2004). The formula to determine the approximate yield to maturity is:

Approximate yield to maturity (Y') = [ Annual interest payment + [ (Principal payment - Price of bond) / Number of years to maturity ] ] / [.6(Price of bond) + .4(Principal payment) ]

The yield to maturity is usually given and is not computed in some cases. However, when the bond yield is determined through formula, or given tables, yield must then be adjusted for tax considerations. Yield to maturity indicates how much the corporation has to pay on a before-tax basis. The interest payment of debt is tax-deductible expense. Since interest is tax-deductible, its true cost is less than its stated cost because the government is picking up part of the tab by allowing the firm to pay less tax. The after tax cost of debt is actually the yield to maturity time one minus the tax rate (Block & Hirt, 2004)

. Costs of Preferred Stock

The cost of preferred stock is similar to the cost of debt in that a constant annual payment is made, but dissimilar in that there is no maturity date on which a principal payment must be made. The yield on preferred stock is determined by dividing the annual dividend by the current price. This represents the rate of return to preferred stockholders as well as at the annual cost to the corporation for the preferred tock issue. A new share of preferred stock has a selling cost called floatation cost. The proceeds to the firm are equal to the selling price in the market minus the floatation cost. A preferred stock dividend is not tax-deductible expense. Therefore, there is no downward tax adjustment (Block & Hirt, 2004).

Costs of Common Equity

The cost of common stock is more involved than determining the cost of preferred stock. One approach is using the dividend valuation model, where the current price of common stock is determined by dividing dividend at the end of the first year (or period) to the net of required rate of return less constant growth rate in dividend ( P = D / (K - g)). The formula can be arranged to solve for required rate of return. Required rate of return can be determined by dividing the dividend at the end of the first year (or period) to the price of the stock today, then add the constant growth rate in dividends ( K = ( D / P ) + g ) (Block & Hirt, 2004).

Another approach that can be used to determine the cost of common equity is capital asset pricing model. The required rate of return on common is determined by adding the risk-free rate of return (usually the current rate on Treasury Bill securities) to the factor of beta coefficient times the net of return in the market as measured by an appropriate index less the risk-free rate of return ( K = R + ( K - R ) ) (Block & Hirt, 2004).

The purchasers of new shares of common stock are the only source of capital. For many corporations the most important source of ownership or equity capital is retained earnings, an internal source of funds. An opportunity cost is involved in retained earnings. The funds could be paid out to the current stockholders in the form of dividends, and then redeployed by the stockholders in other stocks, bonds, real estate, and so on. The cost of retained earnings is equivalent to the rate of return on the firm's common stock. Cost of retained earnings is determined by the sum of dividend at the end of the first year divided by the price of the stock today, and constant growth rate in dividends ( K = ( D / P ) + g) (Block & Hirt, 2004).

There is also cost associated to issuing new common stock. This is determined by the sum of dividend at the end of the first year divided by the net of the price of the stock today less flotation or selling costs, and the constant growth rate in dividends ( K = ( D / ( P + F ) ) + g ) (Block & Hirt, 2004).

Long-Term Financing Alternatives

Corporate debt has increased dramatically