Long term financing

The capital market you may remember deals with bonds and stocks. Within the capital market there exists both a primary and a secondary market. A primary market is a â€Å"new issues† market. It is here that funds rose through the sale of new securities flow from the buyers of securities to the issuers of securities. In a secondary market, existing securities are bought and sold. Transactions in these already existing securities do not provide additional funds to finance capital investment. A large company typically raises funds both publicly and privately. With a public issue, securities are sold to hundreds and often thousands of investors under a formal contract overseen by federal and state regulatory authorities. A private placement on the other hand, is made to a limited number of investors, sometimes only one, and with considerably less regulation. An example of a private placement might be a loan by a small group of insurance companies to a corporation. Thus, the two types of security issues differ primarily in the number of investors involved and in the regulations governing issuance. When a company opted for expansion, it obviously must be financed. Often the seed money (i.e. the initial financing) comes from the founders and their families and friends. For some companies, this is sufficient to get things launched, and by retaining future earnings they need no more external equity financing. For others infusions of additional external equity are necessary. Venture Capital: venture capital represents funds invested in a new enterprise. Wealthy investors and financial institutions are the major sources of venture capitals. Debt funds are sometimes provided, but it is mostly common stock that is involved. This stock is almost always initially placed privately. Initial Public Offerings: If the enterprise is successful, the owners may want to â€Å"take the company public† with a sale of common stock to outsiders. Often this desire is prompted by venture capitalists, who want to realize a cash return on their investment. In another situation, the founders may simply want to establish a value, and liquidity, for their common stock. Initial Public Offerings are accomplished through underwriters. Bonds: a bond is a long term debt instrument with a final maturity generally being 10 years or more. If the security has a final maturity shorter than 10 years, it is usually called a note. To fully understand bonds, we must be familiar with certain basic terms and common features. Par value for a bond represents the amount to be paid the lender at the bond’s maturity. It is also called face value or principal. Coupon rate is the interest rate on a bond for example a 13% coupon rate indicates that the issuer will pay bondholders $ 130 per annum for every $1000 par value bond that they hold. Bonds almost always have a stated maturity. This is the time when the company is obligated to pay the bondholder the par value of the bond. Preferred stocks: it is a hybrid form of financing, combining features of debt and common stock. In the event of liquidation a preferred stockholder’s claim on assets comes after that of creditors but before that of common stock holders. Usually, this claim is restricted to the par value of the stock, if the par value of a share of preferred stock is $100, the investors will be entitled to a maximum of $100 in settlement of the principal amount. Term loans: commercial banks are a primary source of term financing. Two features of a bank term loan distinguish it from other types of business loans. First, a term loan has a final maturity of more than 1 year. Second it most often represents credit extended under a formal loan agreement. For the most part, these loans are repayable in periodic installments. Quarterly, semiannually, or annual – that covers both interest and principal. Lease financing: a lease is a contract; by its terms the owner of an asset (the lessor) gives another party (the lessee) the exclusive right to use the asset, usually for a specific period of time, in return for the payment of rent. Most of us are familiar with leases of houses, apartments, officers or automobiles. Recent decades have seen an enormous growth in the leasing of business assets, such as cards and trucks, computers, machinery and even manufacturing plants. An obvious advantage, the lessee incurs several obligations. First and foremost is the obligation to make periodic lease payments, usually monthly or quarterly. Almost, the lease contact specifies who is to maintain the asset. The decision to borrow rests on the relative timing and magnitude of cash flows. Under the two financing alternatives, as well as on the discount rate employed. To evaluate whether or not a proposal for financing makes economic sense one should compare the proposal with financing the asset with debt. References Neil Seitz and Mitch Ellison (2004), Capital Budgeting and Long-Term Financing Decisions Richard H. Bernhard, (2005), Capital Budgeting and Long-Term Financing Decisions, 2d ed Robert G. Beaves (2005), Capital Budgeting and Long-Term Financing Decisions. Long Term Financing It offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. The risk in this model comprise of systematic risk means risk undiversifiable risk or market risk. This Model basically takes into account asset’s sensitivity to non-diversifiable risk RE: (Capital asset pricing model From Wikipedia, the free encyclopedia). Earlier pricing models do not reflect changes in financial markets but with the emergence of Financial Pricing Models in form of Capital Pricing Models and Discounted Cash Flow models, changes in financial market, risk and return on individual investment can be easily ascertained RE: ( http://www.business.uiuc.edu/~s-darcy/present/ratemake.ppt#256,1,Ratemaking:   A Financial Economics Approach). CAPM is based on certain assumptions such as investors should be rational, fixed quantity of assets, perfect efficient capital markets, production plans are fixed, no inflation, no change in level of interest rate, similar expectation. However having numerous advantage of this model it is also affected by certain limitations and based on certain assumptions which does not perfectly exists. As it fails to appear adequate variation in stock returns, it assumes that there are no taxes or transaction cost which is not suitable in prevailing market situation. It assumes all assets of fixed quality which can never be possible, every market is not perfectly efficient, it varies on the basis of several factors. Inflation makes direct effect on the interest rate so can it be possible to remain unaffected with such change. In comparison to previous Model, Discounted Cash Flow Model (DCF) helps to determine that what one person is willing to pay today in order to obtain the expected cash flow in future years. In short, it can be said that Discounted cash Flow Model is the method of conversion of futures earning in today’s money. DCFM helps in calculation of cash needed to be invested to receive expected cash flow in future years. The DCFM reflects following Reference:- 1.   The time Value of money means investor must be compensated for the delay of their cash   flow. Risk Premium states that investor can demand high amount in form compensation.   The key inputs in Discounted Cash Flow Model are discount rate, cash flows and growth to get future cash flows. This model helps in determining  Ã‚   the company’s current value according to its estimated future cash flows. DCFM is an important tool in making judgment about company performance. However DCFM are powerful, but they have certain limitations as they are limited to mechanical valuation, small changes in inputs may result in large changes in the value of a company. DCFM are not suitable for short term investment as it focus on long term investing RE: (http://pages.stern.nyu.edu/~adamodar/pdfiles/dcfinput.pdf). So, from the study of both the model it can be concluding that both are suitable at their own place subject to consideration of certain assumption and limitation. The company’s evaluates various debts policy and dividend policy to arrive at final decision so that maximum benefit can be provided to company, shareholder, creditors or other persons. To valuate debts and equities various theories are discussed in connection with the sum of debt or equity needed in the organization. Cost of capital play a very important role in selection of the amount of debt and equity such as cost of debt, cost of preference shares, cost of debentures, cost of common shares etc. Then to identify factors which affect capital structure such as political risk, cash flows, discount rate and terminal value. Calculation of net present value, interest rate of return and adjusted net present value is done to ascertain the suitability of capital budget.   So first, cash flow forecasting is to be done by adopting various principles. Then categorization of cash require is made in form of shorter cash, medium term and long term. Then the capital structure is decided by considering various aspects such as cost of equity capital. Then after having profits the company decide whether whole or part of  Ã‚   profit is distributed. The factors should be considered while taking the decision policy decision. Then procedure for payment of dividend is sketched and then impact of divided is noted on the position of shareholders RE: (http://www.cma-srilanka.org/pub/professionalII.pdf). Hence it is clear from the evaluation of debt/equity mix and dividend policy that how much they are necessary to strengthen company’s position. Therefore it is advisable that there must be judicious mixture of debt and equity that must add value by reducing taxes and strengthening management as too much debt result in heavy loss of business and perhaps a costly organization. REFERENCE Referred to sites:- 1.   http://www.business.uiuc.edu/~s-darcy/present/ratemake.ppt#256, 1, Ratemaking:   A   Financial Economics Approach Ratemaking: A Financial economies Approach 2.   http://www.biu.ac.il/soc/sb/stfhome/lauterbah/794/part6/fama_capm.pdf The Capital Asset Pricing Model: Theory and Evidence Eugene F. Fama and Kenneth R. French 3.   http://www.valuebasedmanagement.net/methods_dcf.html DCF method Discounted Cash Flow 4.   http://www.cma-srilanka.org/pub/professionalII.pdf Internal Control & Risk Management (ICR) Dated 28th August 2007