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7/29/2019 Long-Term Capital Financing
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LONG-TERM
CAPITALMANAGEMENT
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Dr. Mazila Md Yusuf Long-term Financing 2
Introduction
LT Capital Management refers to themanagement of firms long terminvestments (assets) and the sourcesof funding or financing these
investments (assets) Long term investment also known as
capital budgeting
Long term sources of financing thecapital budgeting is called long termcapital
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Dr. Mazila Md Yusuf Long-term Financing 3
Long-term Capital
Long-term capital is sources offinancing to fund companys long-term investments or fixed assets.
The term capital denotes the long-term funds of a firm.
There are two types of capital:
debt capital and
equity capital.
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Dr. Mazila Md Yusuf Long-term Financing 4
The Firms Capital Structure
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Dr. Mazila Md Yusuf Long-term Financing 5
Sources of Long-TermFinancing/Capital
1. Equity Financing:
a. Common Stock
b. Preferred/PreferenceStock
2. Debt/Bonds Financing
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Dr. Mazila Md Yusuf Long-term Financing 6
Differences BetweenDebt and Equity Capital
The key differences between debtand equity:
1. Voice in Management
2. Claims on income and assets
3. Maturity
4. Tax treatment
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Dr. Mazila Md Yusuf Long-term Financing 7
1. Voice in Management
Debt
creditors to the firm
no voting rights,
only when firmviolated its statedcontractualobligations to them.
Equity
owners of the firm
voting rights to
select the board ofdirectors
voting on specialissues.
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Dr. Mazila Md Yusuf Long-term Financing 8
2. Claims on Income andAssets
Debt
first claims onfirms income
first claims onproceeds of sale ofassets if firm fails
Equity
last claims onincome i.e. after of
all creditors havebeen satisfied
last claims onproceeds of sale ofassets if firm fails
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Dr. Mazila Md Yusuf Long-term Financing 9
3. Maturity
Debt
has fixed maturityperiod
require repaymentof principal onmaturity
Equity
permanent form offinancing
does not requirerepayment ofprincipal
liquidated only
during bankruptcyproceedings.
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Dr. Mazila Md Yusuf Long-term Financing 10
4. Tax Treatment
Debt
interest paymentsare tax-deductible
tax deductionexpenses will lowerthe firms taxes
thus, cost of debt
financing is lower
Equity
dividends paymentsare not tax-deductible
thus, firms taxes arenot lower
therefore, cost ofequity financing is
higher
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Dr. Mazila Md Yusuf Long-term Financing 11
1. Equity Financing
Equities are sold (issued) by acompany either:
1. at the formation of the company
2. when additional financing areneeded.
Equities are issued in the Primary
Market by the company and resoldby the Equities holders in theSecondary Market.
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Dr. Mazila Md Yusuf Long-term Financing 12
A. Common Stock
Features of Common Stock
represents ownership, the holders arethe true owner of the company
no maturity date, but exists as long asthe company does
stockholders have the residual claim on
the firms income and assets
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Dr. Mazila Md Yusuf Long-term Financing 13
Features of CommonStock (cont)
stockholders receive variable returns inthe form of dividends
stockholders have pre-emptive rights to
buy any new issued stocks stockholders have the right to vote for
the Board of Directors
stockholders have unlimited, limitedliabilities
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Dr. Mazila Md Yusuf Long-term Financing 14
B. Preferred/PreferenceStock
Features of Preferred Stock
a hybrid of common stock and bond.
has no maturity date
has a par value of usually RM100 pershare
stockholders receive fixed amount of
dividends every year
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Dr. Mazila Md Yusuf Long-term Financing 15
Features of PreferredStock (cont)
stockholders have no voting rights
stockholders get claims on profits andassets after bondholders but before
common stockholders sometimes carry special features such
as callable, cumulative, participativeand convertibility.
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Dr. Mazila Md Yusuf Long-term Financing 16
2. Debt/Bonds Financing
Features of Debt/Bondsdebt/bond is a long-term debt
instrument issued by a firm
holders are promised a fixed amount ofinterest every year until maturity period
interest rate also known as coupon rateand thus interest amount is calculatedas the coupon rate percentage of thepar value
par value or face value of bond isnormally RM 1000
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Dr. Mazila Md Yusuf Long-term Financing 17
Features of Debt/Bonds(cont)
maturity period is between 10 to 30years
issuer (firm) also pays the holdersprincipal payment (par value) atmaturity period
holders are considered as creditors tofirm
holders have no voting rightsholders have the first claims on profits
and assets of firm.
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Cost of Long-Term Capital
Each specific sources has specific method tocalculate its cost
The cost must always be stated on an after-tax basis because the cost of financing to thefirm is a return to the providers of the capitaland providers will get their returns only afterfirm pays taxes.
Apart from cost of paying providers of funds,firm also incurred flotation costs total costsof selling and issuing securities
Dr. Mazila Md Yusuf Long-term Financing 18
1 Th C t f C St k
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1. The Cost of Common StockEquity
Two different ways to estimate the cost ofcommon equity:
1. any form of the dividend valuation model
2. the capital asset pricing model (CAPM). The dividend valuation models are based on the
premise that the value of a share of stock isbased on the present value of all future
dividends.
Th C t f C St k
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The Cost of Common StockEquity (cont.)
Constant growth (Gordon) model:
Where = cost of common stock = expected dividend
= market price of stock
= constant growth individend
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Th C f C S k
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Dr. Mazila Md Yusuf Long-term Financing 21
ks = D1/P0 + g
For example, assume a firm has just paid a dividend of$2.50 per share, expects dividends to grow at 10%
indefinitely, and is currently selling for $50.00 per share.
First, D1 = $2.50(1+.10) = $2.75, and
kS = ($2.75/$50.00) + .10 = 15.5%.
The Cost of Common Stock(cont.)
Using Constant Dividend Growth Model
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The Cost of Common Stock(cont.)
CAPM Model:
Where = risk free return
= beta coefficient
= market return Note: market return risk free
return = market risk premium
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Dr. Mazila Md Yusuf Long-term Financing 23
ks = rF + b(kM - RF).
For example, if the 3-month T-bill rate is currently 5.0%,
the market risk premium is 9%, and the firms beta is
1.20, the firms cost of retained earnings will be:
ks = 5.0% + 1.2 (9.0%) = 15.8%.
Using CAPM Approach
The Cost of Common Stock(cont.)
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Dr. Mazila Md Yusuf Long-term Financing 24
The CAPM differs from dividend valuationmodels in that it explicitly considers thefirms risk as reflected in beta.
On the other hand, the dividend valuationmodel does not explicitly consider risk.
Dividend valuation models use the market
price (P0) as a reflection of the expectedrisk-return preference of investors in themarketplace.
The Cost of Common Stock(cont.)
The Cost of Common Stock
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Dr. Mazila Md Yusuf Long-term Financing 25
Although both are theoretically equivalent,dividend valuation models are oftenpreferred because the data required aremore readily available.
The two methods also differ in that thedividend valuation models (unlike theCAPM) can easily be adjusted for flotationcosts when estimating the cost of new
equity.
The Cost of Common Stock(cont.)
Th C t f C St k
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Dr. Mazila Md Yusuf Long-term Financing 26
The Cost of Common Stock(cont.)
Cost of Retained Earnings (kE)- Cost of retained earnings to the firmis the same as the cost of an
equivalent fully subscribed issue ofadditional common stock
- it means cost of retained earnings
equal to cost of common stock equity-
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The Cost of Common Stock(cont.)
Cost of New Equity (kn)
Using Constant Dividend Growth Model
Dr. Mazila Md Yusuf Long-term Financing 27
Continuing with the previous example, how much wouldit cost the firm to raise new equity if flotation costs
amount to $4.00 per share?
= [$2.75/($50.00 - $4.00)] + .10 = 15.97 %
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Dr. Mazila Md Yusuf Long-term Financing
Duchess Corporation is contemplating the issuance of a
10% preferred stock that is expected to sell for its $87-per
share value. The cost of issuing and selling the stock is
expected to be $5 per share. The dividend is $8.70 (10%
x $87). The net proceeds price (Np) is $82 ($87 - $5).
KP = DP/Np = $8.70/$82 = 10.6%
2. The Cost of Preferred Stock
Note: Net Proceed = Market Price Flotation Cost
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Dr. Mazila Md Yusuf Long-term Financing 29
Since the cost must be on after-tax costs, thecost of bonds/debt must first calculate theBefore-Tax Cost of Bonds/Debt
The before-tax cost of debt can be calculatedin any one of three ways:
1. Using cost quotations
2. Calculating the cost
3. Approximating the cost
3. The Cost of Long-TermDebt/Bond (cont.)
Th C f L T
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Dr. Mazila Md Yusuf Long-term Financing 30
Before-Tax Cost of Debt
1. Using Cost Quotations; that is basedthe cost on: a.) our quotation of cost or
b.) cost of similar risk bond
a. When the net proceeds (MP FC) from
the sale of a bond equal its par value,the before-tax cost equals the couponinterest rate.
The Cost of Long-TermDebt/Bond (cont.)
h C f
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The Cost of Long-TermDebt/Bond (cont.)
b. A second cost quotation that issometimes used is the yield-to-maturity (YTM) on a similar risk bond.
Dr. Mazila Md Yusuf Long-term Financing 31
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Dr. Mazila Md Yusuf Long-term Financing 32
Before-Tax Cost of Debt2. Calculating the Cost
This approach finds the before-tax cost
of debt by calculating the internal rateof return (IRR), i.e. the actual costs tothe firm for having the bonds financing
IRR can be calculated using: (a) trial
and error, (b) a financial calculator, or(c) a spreadsheet.
The Cost of Long-TermDebt/Bond (cont.)
The Cost of Long Term
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Dr. Mazila Md Yusuf Long-term Financing 33
Before-Tax Cost of DebtApproximating the Cost using an
equation
The Cost of Long-TermDebt/Bond (cont.)
The Cost of Long Term
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The Cost of Long-TermDebt/Bond (cont.)
Example :Duchess Corporation, a major hardwaremanufacturer, is contemplating selling$10 million worth of 20-year, 9% couponbonds with a par value of $1000. Becausecurrent market interest rates are greaterthan 9%, the firm must sell the bonds at
$980. Flotation cost are 2% or $20. Thenet proceeds to the firm for each bond istherefore $960 ($980 - $20).
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The Cost of Long Term
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Before-Tax Cost of DebtApproximating the Cost
The Cost of Long-TermDebt/Bond (cont.)
Th C t f L T
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The Cost of Long-TermDebt/Bond (cont.)
The after-tax cost of bonds/debt:
Find the after-tax cost of debt for Duchessassuming it has a 40% tax rate:
= 9.4% (1-.40) = 5.6%
This suggests that the after-tax cost of raisingdebt capital for Duchess is 5.6%.
Dr. Mazila Md Yusuf Long-term Financing 36
W i ht d A C t
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Weighted Average Costof Capital(WACC)
When firm has a mixture of capital asthe sources of its LT financing, howmuch would its overall cost of capital
be?
The overall cost is known asweighted average cost of capital
(WACC) Why?
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Th W i ht d A C t
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The Weighted Average Costof Capital (cont)
WACC reflects the expected averagefuture cost of funds over the long-run
WACC is found by weighting the cost of
each specific type of capital by itsproportion in the firms capitalstructure.
In equation, WACC can be written as:
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Dr. Mazila Md Yusuf Long-term Financing 39
WACC Equation
where = proportion of long-term debt in
capital structure = proportion of preferred stock in
capital structure
= proportion of common stockequity in capital structure
= 1.0
)*()*()*( ccppiia kwkwkwk
iw
pw
cw
cpiwww
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Dr. Mazila Md Yusuf Long-term Financing 40
The Weighted Average Cost ofCapital (cont)
Determine Capital Structure Weights
One method uses book valuesfrom the firms balance
sheet. For example, to estimate the weight for debt,
simply divide the book value of the firms long-term debt
by the book value of its total assets.
To estimate the weight for equity, simply divide the total
book value of equity by the book value of total assets.
f
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Dr. Mazila Md Yusuf Long-term Financing 41
A second method uses the market valuesof the firms debt
and equity. To find the market value proportion of debt,
simply multiply the price of the firms bonds by the numberoutstanding. This is equal to the total market value of the
firms debt.
Next, perform the same computation for the firms equity
by multiplying the price per share by the total number of
shares outstanding.
The Weighted Average Cost ofCapital (cont)
Capital Structure Weights
h h d f
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Dr. Mazila Md Yusuf Long-term Financing 42
The Weighted Average Cost ofCapital (cont)
Capital Structure Weights
Finally, add together the total market value of the firms
equity to the total market value of the firms debt. Thisyields the total market value of the firms assets.
To estimate the market value weights, simply divide the
market value of either debt or equity by the market value
of the firms assets .
h i h d C f
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Dr. Mazila Md YusufLong-term Financing
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The Weighted Average Cost ofCapital (cont)
Capital Structure Weights
For example, assume the market value of the firms debt is $40
million, the market value of the firms preferred stock is $10million, and the market value of the firms equity is $50 million.
Dividing each component by the total of $100 million gives us
market value weights of 40% debt, 10% preferred, and 50%common.
Th W i h d A C f
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Dr. Mazila Md Yusuf 44
The Weighted Average Cost ofCapital (cont)
Capital Structure Weights
Using the costs previously calculated along with the
market value weights, we may calculate the weighted
average cost of capital as follows:
WACC = .40(5.6%) + .10(10.6%) + .50(15.8%)
= 11.2%
This assumes the firm has sufficient retained earnings tofund any anticipated investment projects.