financial management, capital, cost of capital

1. Long Term (Strategic)
Decisions
Long Term Financing And Cost Of Capital
-Group 5

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. 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. • 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. • 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. 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. Overview of Cost Capital

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

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. The Cost of Debt before tax..
• When debts are issued at par:

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. 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. 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. 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. 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. 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. • 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. Sources Of Finance
Basic Coverage, Debt or Capital

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

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.
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27. Sources of Debt Capital
• Commercial banks
• Asset-based lenders
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28. Commercial Banks
• Short-term loans
– Commercial loans
– Lines of credit
• Intermediate and long-term loans
– Installment loans and contracts
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-Lopez, Zenn Vanrim

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.
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30. Sources of Debt Capital
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•
•
•
•
•
Commercial banks
Asset-based lenders
Vendor financing (trade credit)
Equipment suppliers
Commercial finance companies
Saving and loan associations
$$
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31. Sources of Debt Capital
•
•
•
•
•
•
•
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Stock brokerage houses
Insurance companies
Credit unions
Bonds
Private placements
Small Business Investment Companies (SBICs)
Small Business Lending Companies (SBLCs)

32. Internal Methods of Financing
• Factoring - selling accounts receivable
outright.
• Leasing - assets rather than buying them.
• Credit cards
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33. Cost Of Long Term Debt

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. 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. 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. 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. 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. • 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. 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. Different Types of Bonds
•
•
•
•
•
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Callable Bonds
Put Bonds
Convertible Bonds
Deep Discount Bonds
Income Bonds
Floating-Rate Bonds
-Aranda, Dianalyn D.

42. Put bonds
• Put provisions
– Put price
– Put date
– Put deferment
• Extendible bonds
• Value of the put feature
• Cost of the put feature

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. 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. 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. Thank You!!!