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financial management - long term (strategic) decision

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financial management, capital, cost of capital

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financial management - long term (strategic) decision

  1. 1. Long Term (Strategic) Decisions Long Term Financing And Cost Of Capital -Group 5
  2. 2. 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.
  3. 3. 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.
  4. 4. • 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.
  5. 5. • 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
  6. 6. Strategic Decisions Administrative Decisions Operational Decisions Strategic decisions are longterm decisions. Administrative decisions are taken daily. Operational decisions are not frequently taken. These are considered where The These are short-term based future planning is concerned. 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
  7. 7. Overview of Cost Capital
  8. 8. What is cost of 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.
  9. 9. Various Assumptions • Firms business and financial risks are unaffected by the acceptance and financing of projects. • Firms financial structure is assumed to remain fixed.
  10. 10. Explicit cost • The explicit cost of capital is associated with the raising of funds. • In other words, it is nothing but internal rate of return.
  11. 11. Implicit cost • Implicit cost of capital is opportunity cost, if money is used one of best alternatives for effective use of resources.
  12. 12. 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.
  13. 13. The Cost of Debt before tax.. • When debts are issued at par:
  14. 14. After tax.. • Interest expense is tax deductible. • Therefore, when a company pays interest, the actual cost is less than the expense. -Olar KC Lee
  15. 15. Capital Asset Pricing Model • A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.
  16. 16. The Weighted Average Cost of Capital • 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 W ACC w dkd w pk p w cs k cs
  17. 17. Finding the Weights • 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
  18. 18. Book-value 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.
  19. 19. Market-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.
  20. 20. • 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
  21. 21. Sources Of Finance Basic Coverage, Debt or Capital
  22. 22. Three Types of Capital Capital is any form of wealth employed to produce more wealth for a firm. • 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.
  23. 23. 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.
  24. 24. 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. 24
  25. 25. Sources of Equity Financing • • • • • • • 25 Personal savings Friends and relatives Angels Corporations Venture capital companies Public stock sales Warrants
  26. 26. 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. 26
  27. 27. Sources of Debt Capital • Commercial banks • Asset-based lenders 27
  28. 28. Commercial Banks • Short-term loans – Commercial loans – Lines of credit • Intermediate and long-term loans – Installment loans and contracts 28 -Lopez, Zenn Vanrim
  29. 29. 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. 29
  30. 30. Sources of Debt Capital • • • • • • Commercial banks Asset-based lenders Vendor financing (trade credit) Equipment suppliers Commercial finance companies Saving and loan associations $$ 30
  31. 31. Sources of Debt Capital • • • • • • • 31 Stock brokerage houses Insurance companies Credit unions Bonds Private placements Small Business Investment Companies (SBICs) Small Business Lending Companies (SBLCs)
  32. 32. Internal Methods of Financing • Factoring - selling accounts receivable outright. • Leasing - assets rather than buying them. • Credit cards 32
  33. 33. Cost Of Long Term Debt
  34. 34. 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
  35. 35. 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
  36. 36. 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
  37. 37. 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
  38. 38. 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?
  39. 39. • What is rated: Bond Ratings – 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.
  40. 40. 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
  41. 41. Different Types of Bonds • • • • • • Callable Bonds Put Bonds Convertible Bonds Deep Discount Bonds Income Bonds Floating-Rate Bonds -Aranda, Dianalyn D.
  42. 42. Put bonds • Put provisions – Put price – Put date – Put deferment • Extendible bonds • Value of the put feature • Cost of the put feature
  43. 43. 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
  44. 44. 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.
  45. 45. 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
  46. 46. Thank You!!!