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Capital Structure and Long-Term Financing Strategies

There are many strategies one must consider to successfully maintain his or her financial needs. When it comes to finances one can get lost in the enormity of the amount of options that are available. When starting an organization the type of capital structure and long-term financing strategies must be taken into consideration to successfully run the company. In doing so, the organization will have to compare and contrast the capital asset pricing model (CAPM) with the discounted cash flows method (DCFM). The skill of comparing and contrasting financial options will help evaluate and organize the debt/equity mix and dividend policy. Realizing the major constituents of the financial market, the cost of various debt and equity instruments will in turn help with in an organization to make better decisions. The organization must then decide what type of long-term finance alternatives will most likely benefit it.

CAPM vs DCFM

The main idea behind the capital asset pricing model (CAPM) is the investor's requirement to be compensated. This occurs in two ways: first, the time-value of money; and two, the risk involved in the investment. The CAPM states that the expected return of an investment must equal or surpass the risk-free rate of return. An additional return is required by investors for undertaking additional risk. In other words, there is an expected return of a security or portfolio which equals the rate on a risk-free security plus a risk premium (Investopedia, 2006). If this investment does not meet or beat the required return, then the investment should not be undertaken. The formula for this, including beta inputs, reads as follows:

The beta factor in the formula reflects the overall risk in investing in a large market, such as the NY Stock exchange. Individual companies also have a beta, which is that company's risk compared to the overall market. Beta is a measure of the volatility of the security relative to the asset class. If a company has a beta of 3.0, then it is believed to have 3 times more risk than the overall market (Value Based, 2006).

The discounted cash flow method (DCFM) is a valuation method to estimate the attractiveness of an investment opportunity. This analysis tool uses future free cash flow projections and discounts them to arrive at a present value, which is used for an evaluation of the potential on an investment. With all the variations in existence regarding the uses of cash flows and discount rates in a DCFM analysis, the main purpose of the DCFM is to basically estimate the money received from an investment and to adjust for the time value of money (Investopedia, 2006). The DCFM has limitations, however, and is dependent on the inputs to correctly determine outputs. As with other financial tools, what goes in is what comes out. Small changes in inputs result in large changes in the value of a company. Instead of projections going on to infinity, a terminal value approach is at times used. As an example, a simple annuity is used to estimate the terminal value beyond 10 years. This is done because it is harder to create realistic projections of cash flows as time increases.

The formula for the DCF method is as follows:

Similarities between the CAPM and the DCFM include the future values and yields of investments, the attractiveness of where and how much money to invest, and the presence of the time-value of money and the risk premium. Differences include the CAPM's fixed return, namely in the form of a security or portfolio, versus DCF's use of discounting investment dollars at the outset and having more opportunity for free cash flows in the future.

Debt/Equity Mix

Debt for a company is realized through different financing costs to the company, including stocks. The cost of debt is measured by the interest that is paid to bondholders. A company has to take into account the current rates of interest when determining the cost of debt. This can be done by calculating the yield to maturity, as well as the tax rate. This can be computed as follows, where T equals the tax (percentage):

(Block & Hirt, 2005 p315).

The cost of preferred stocks is similar to the cost of debt, except that there is no maturity date for preferred stocks. Common stock must also be figured into the debt of a company. The demands of the current and future stockholders must be taken into account when figuring common stock, as new purchasers of common stock affect the equity in a company (Block & Hirt, 2005).

Common stock equity capital contributes to the retained earnings of the company, or how much money the company keeps for themselves. Unlike previous common stocks, new common stock, like preferred stock, takes into account selling cost. To determine which source of financing is best, one must look at the debt-equity mix. The average cost of capital, when plotted on a graph, produces a u-shaped curve:

(Block & Hirt, 2004 P323 )

Based on the curve, most companies would like to find themselves in the middle of such a curve as this equates a relatively healthy mix of debt to equity. A higher debt will lead to a higher cost for sources of financing because of the increase in financial risk (Block & Hirt, 2005).

The rate of debt to equity will also affect a company's dividend policy, or "the decision to pay dividends" (Campbell et al 1998). Higher equity may lead to a greater payment of dividends. Payment of dividends may show that the company has good potential for growth, which may drive up stock prices, but also may signify a lack of viable investment opportunities, which would negatively affect stock prices. Also, dividend payouts cause an increase in personal income taxes, which will also be viewed unfavorably (Campbell et al 1998). The best mix would be to pay a minimal amount of dividends, then reinvest the retained earnings to show the company's willingness towards longevity in the field.

Characteristics of Costs of Various Debt and Equity Instruments

The capital structure of an organization is greatly influenced by the costs of capital. There may be various methods through which an organization can raise capital, and it is important for the financial manager to determine which methods are best suited for the organization. As discussed above, debt, preferred stock, and common stock are three examples of methods through which an organization can raise