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financial management - long term (strategic) decision
Long Term (Strategic)
Long Term Financing And Cost Of Capital
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.
• Strategic decisions have major resource propositions for an
organization. These decisions may be concerned with
possessing new resources, organizing others or reallocating
• 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
• 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 are longterm decisions.
Administrative decisions are
Operational decisions are not
These are considered where The These are short-term based
future planning is concerned.
These are medium-period based
Strategic decisions are taken in
Accordance with organizational
mission and vision.
These are taken according to
strategic and operational
These are taken in accordance
with strategic and
These are related to overall
Counter planning of all
These are related to working of
employees in an Organization.
These are related to production.
These deal with organizational
These are in welfare of
employees working in an
These are related to production
and factory growth.
-Sebastian Mico Zuasola
What is cost of capital?
• Cost of capital is the minimum required rate of
earning or the cut off rate for capital
• It is also referred to as a ―hurdle‖ rate because
this is the minimum acceptable rate of return.
• Firms business and financial risks are
unaffected by the acceptance and financing of
• Firms financial structure is assumed to remain
• The explicit cost of capital is associated with
the raising of funds.
• In other words, it is nothing but internal rate of
• Implicit cost of capital is opportunity cost, if
money is used one of best alternatives for
effective use of resources.
• 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
The Cost of Debt before tax..
• When debts are issued at par:
• Interest expense is tax deductible.
• Therefore, when a company pays interest, the
actual cost is less than the expense.
-Olar KC Lee
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.
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 pk p
w cs k cs
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
• 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.
• 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.
• Calculation of market-value weights is very
similar to the calculation of the book-value
• 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 Finance
Basic Coverage, Debt or Capital
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.
• Represents the personal investment of the owner(s) in
• 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
• Means that an entrepreneur must give up some
ownership in the company to outside investors.
• Must be repaid with interest.
• Is carried as a liability on the company’s balance
• 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.
Sources of Equity Financing
Friends and relatives
Venture capital companies
Public stock sales
• The first place an entrepreneur should look for
• 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.
Sources of Debt Capital
• Commercial banks
• Asset-based lenders
• Short-term loans
– Commercial loans
– Lines of credit
• Intermediate and long-term loans
– Installment loans and contracts
-Lopez, Zenn Vanrim
• 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.
Sources of Debt Capital
Vendor financing (trade credit)
Commercial finance companies
Saving and loan associations
Sources of Debt Capital
Stock brokerage houses
Small Business Investment Companies (SBICs)
Small Business Lending Companies (SBLCs)
Internal Methods of Financing
• Factoring - selling accounts receivable
• Leasing - assets rather than buying them.
• Credit cards
Long Term Debt
• Corporate debt can be short-term (maturity less than one year)
• 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
– Denomination (Par
– Annual Coupon, Dates
of Coupon Payments
– Sinking Funds
– Call Provisions
• Features that may change
– Market price
• 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
– 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
– 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.
• Replacing all or part of a bond issue is called
• Bond refunding raises two questions:
– Should firms issue callable bonds?
– Given that callable bonds have been issued, when
should the bonds be called?
• What is rated:
– The likelihood that the firm will default.
– The protection afforded by the loan contract in the event of
• 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.
• Anything less than an S&P or a Moody’s is a junk
• 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
Deep Discount Bonds
-Aranda, Dianalyn D.
• Put provisions
– Put price
– Put date
– Put deferment
• Extendible bonds
• Value of the put feature
• Cost of the put feature
• 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
• 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
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
• In the event of default, it is easier to ―work
out‖ a private placement.
-Andaya, Kimberly Camille