Long Term (Strategic) Decisions

Long Term Financing And Cost Of Capital

-Group 5

Strategic decisions are the decisions that are concerned with whole environment in which the firm operates, the entire resources and the people who form the company and the interface between the two.

Characteristics/Features of Strategic Decisions

• Strategic decisions have major resource propositions for an organization. These decisions may be concerned with possessing new resources, organizing others or reallocating others.

• Strategic decisions deal with harmonizing organizational resource capabilities with the threats and opportunities.

• Strategic decisions deal with the range of organizational activities. It is all about what they want the organization to be like and to be about.

• Strategic decisions involve a change of major kind since an organization operates in ever-changing environment.

• Strategic decisions are complex in nature.

• Strategic decisions are at the top most level, are uncertain as they deal with the future, and involve a lot of risk.

• Strategic decisions are different from administrative and operational decisions. Administrative decisions are routine decisions which help or rather facilitate strategic decisions or operational decisions. Operational decisions are technical decisions which help execution of strategic decisions

Strategic Decisions Administrative Decisions Operational Decisions

Strategic decisions are long-term decisions.

Administrative decisions are taken daily.

Operational decisions are not frequently taken.

These are considered where The future planning is concerned.

These are short-term based Decisions.

These are medium-period based decisions.

Strategic decisions are taken in Accordance with organizational mission and vision.

These are taken according to strategic and operational Decisions.

These are taken in accordance with strategic and administrative decision.

These are related to overall Counter planning of all Organization.

These are related to working of employees in an Organization.

These are related to production.

These deal with organizational Growth.

These are in welfare of employees working in an organization.

These are related to production and factory growth.

-Sebastian Mico Zuasola

Overview of Cost Capital

• Cost of capital is the minimum required rate of earning or the cut off rate for capital expenditure.

• It is also referred to as a “hurdle” rate because this is the minimum acceptable rate of return.

What is cost of capital?

• Firms business and financial risks are unaffected by the acceptance and financing of projects.

• Firms financial structure is assumed to remain fixed.

Various Assumptions

• The explicit cost of capital is associated with the raising of funds.

• In other words, it is nothing but internal rate of return.

Explicit cost

• Implicit cost of capital is opportunity cost, if money is used one of best alternatives for effective use of resources.

Implicit cost

Example:• I have 100,000, I can deposit it in bank and

earn 3500 as bank interest but I did not invested it in saving bank account and invested in the shares of XYZ company. So, my implicit cost of investment in shares will equal to the bank interest. This is not in money form because, it is not necessary that XYZ company give me my cost investment in shares. But, after thinking, I take the opportunity for getting best reward from investment, so I have taken this decision.

• When debts are issued at par:

The Cost of Debt before tax..

• Interest expense is tax deductible.

• Therefore, when a company pays interest, the actual cost is less than the expense.

After tax..

-Olar KC Lee

• A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

Capital Asset Pricing Model

• If a firm uses both debt and equity financing, the cost of capital must include the cost of each, weighted to proportion of each (debt and equity) in the firm’s capital structure.

• Therefore, a firm’s overall cost of capital must reflect the required return on the firm’s assets as a whole

• Wd= percentage of debt to total capital• Wp= percentage of preference share to total

capital

The Weighted Average Cost of Capital

WACC w k w k w kd d p p cs cs

• The weights that we use to calculate the WACC will obviously affect the result.

• Therefore, the obvious question is: “where do the weights come from?”

• There are two possibilities:– Book-value weights–Market-value weights

Finding the Weights

• One potential source of these weights is the firm’s balance sheet, since it lists the total amount of long-term debt, preferred equity, and common equity.

• We can calculate the weights by simply determining the proportion that each source of capital is of the total capital.

Book-value Weights

• The problem with book-value weights is that the book values are historical, not current, values.

• The market recalculates the values of each type of capital on a continuous basis. Therefore, market values are more appropriate.

Market-value Weights

• Calculation of market-value weights is very similar to the calculation of the book-value weights.

• The main difference is that we need to first calculate the total market value (price times quantity) of each type of capital.

- Mendoza, Maria Bianca

Sources Of FinanceBasic Coverage, Debt

or Capital

Three Types of Capital

• Fixed - used to purchase the permanent or fixed assets of the business (e.g., buildings, land, equipment, and others).

• Working - used to support the small company's normal short-term operations (e.g., buy inventory, pay bills, wages, or salaries, and others).

• Growth - used to help the small business expand or change its primary direction.

Capital is any form of wealth employed to produce more wealth for a firm.

Equity Capital• Represents the personal investment of the

owner(s) in the business.

• Is called risk capital because investors assume the risk of losing their money if the business fails.

• Does not have to be repaid with interest like a loan does.

• Means that an entrepreneur must give up some ownership in the company to outside investors.

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Debt Capital

• Must be repaid with interest.• Is carried as a liability on the

company’s balance sheet.• Can be just as difficult to secure as

equity financing, even though sources of debt financing are more numerous.

• Can be expensive, especially for small companies, because of the risk/return tradeoff.

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Sources of Equity Financing• Personal savings• Friends and relatives• Angels• Corporations• Venture capital companies• Public stock sales• Warrants

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Personal Savings• The first place an entrepreneur should

look for money.

• The most common source of equity capital for starting a business.

• Outside investors and lenders expect entrepreneurs to put some of their own capital into the business before investing theirs.

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Sources of Debt Capital

• Commercial banks• Asset-based lenders

28-Lopez, Zenn Vanrim

Commercial Banks• Short-term loans– Commercial loans– Lines of credit

• Intermediate and long-term loans– Installment loans and contracts

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Asset-Based Borrowing• Businesses can borrow money by

pledging as collateral otherwise idle assets – accounts receivable, inventory, and others

• Advance rate – the percentage of an asset’s value that a lender will lend.

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Sources of Debt Capital• Commercial banks

• Vendor financing (trade credit)• Equipment suppliers• Commercial finance companies• Saving and loan associations

• Asset-based lenders

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Sources of Debt Capital• Stock brokerage houses• Insurance companies• Credit unions• Bonds• Private placements• Small Business Investment Companies

(SBICs)• Small Business Lending Companies

(SBLCs)

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Internal Methods of Financing• Factoring - selling accounts

receivable outright.

• Leasing - assets rather than buying them.

• Credit cards

Cost Of Long Term Debt

Long Term Debt• Corporate debt can be short-term (maturity less

than one year) or long-term.• Different from common stock:

– Creditor’s claim on corporation is specified– Promised cash flows– Most are callable

• Over half of outstanding bonds are owned by life insurance companies & pension funds

• Plain vanilla bonds to “kitchen sink” bonds

Features of a Typical Bond• The indenture usually

lists– Amount of Issue,

Date of Issue, Maturity

– Denomination (Par value)

– Annual Coupon, Dates of Coupon Payments

– Security– Sinking Funds– Call Provisions– Covenants

• Features that may change over time– Rating– Yield-to-Maturity– Market price

Protective Covenants• Agreements to protect bondholders• Negative covenant: Thou shalt not:

– pay dividends beyond specified amount– sell more senior debt & amount of new debt is limited– refund existing bond issue with new bonds paying

lower interest rate– buy another company’s bonds

• Positive covenant: Thou shalt:– use proceeds from sale of assets for other assets– allow redemption in event of merger or spinoff– maintain good condition of assets– provide audited financial information

The Sinking Fund• There are many different kinds of sinking-fund

arrangements:– Most start between 5 and 10 years after initial

issuance.– Some establish equal payments over the life of the

bond.– Most high-quality bond issues establish payments

to the sinking fund that are not sufficient to redeem the entire issue.

• Sinking funds provide extra protection to bondholders.

• Sinking funds provide the firm with an option.-Capuz, Alvin

Bond Refunding• Replacing all or part of a bond issue

is called refunding.• Bond refunding raises two questions:– Should firms issue callable bonds?– Given that callable bonds have been

issued, when should the bonds be called?

Bond Ratings• What is rated:– The likelihood that the firm will default.– The protection afforded by the loan contract in

the event of default.• Who pays for ratings:– Firms pay to have their bonds rated.– The ratings are constructed from the financial

statements supplied by the firm.• Ratings can change.• Raters can disagree.

Junk bonds• Anything less than an S&P or a Moody’s

is a junk bond. • A polite euphemism for junk is high-yield

bond.• There are two types of junk bonds:– Original issue junk—possibly not rated– Fallen angels—rated

• Yield premiums versus default risk

Different Types of Bonds• Callable Bonds• Put Bonds• Convertible Bonds• Deep Discount Bonds• Income Bonds• Floating-Rate Bonds

-Aranda, Dianalyn D.

Put bonds• Put provisions– Put price– Put date– Put deferment

• Extendible bonds• Value of the put feature• Cost of the put feature

Convertible Bonds• Why are they issued?• Why are they purchased?• Conversion ratio:

– Number of shares of stock acquired by conversion• Conversion price:

– Bond par value / Conversion ratio• Conversion value:

– Price per share of stock x Conversion ratio• In-the-money versus out-the-money

More on Convertibles• Exchangeable bonds

– Convertible into a set number of shares of a third company’s common stock.

• Minimum (floor) value of convertible is the greater of:– Straight or “intrinsic” bond value– Conversion value

• Conversion option value– Bondholders pay for the conversion option by

accepting a lower coupon rate on convertible bonds versus otherwise- identical nonconvertible bonds.

Direct Placement Compared to Public Issues

• A direct long-term loan avoids the cost of registration with the SEC.

• Direct placement is likely to have more restrictive covenants.

• In the event of default, it is easier to “work out” a private placement.

-Andaya, Kimberly Camille

Thank You!!!