LONG-TERM CAPITAL MANAGEMENT

Introduction
LT Capital Management refers to the management of firms long term investments (assets) and the sources of funding or financing these investments (assets) Long term investment also known as capital budgeting Long term sources of financing the capital budgeting is called long term capital
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Long-term Capital
Long-term capital is sources of financing to fund companys longterm investments or fixed assets. The term capital denotes the longterm funds of a firm. There are two types of capital:
debt capital and equity capital.
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The Firms Capital Structure

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Sources of Long-Term Financing/Capital

1. Equity Financing:
a. b. Common Stock Preferred/Preference Stock

2.

Debt/Bonds Financing

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Differences Between Debt and Equity Capital

The key differences between debt and equity:
1. 2. 3. 4. Voice in Management Claims on income and assets Maturity Tax treatment

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1. Voice in Management
Debt
creditors to the firm no voting rights, only when firm violated its stated contractual obligations to them.

Equity
owners of the firm voting rights to select the board of directors voting on special issues.

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2. Claims on Income and Assets

Debt
first claims on firms income first claims on proceeds of sale of assets if firm fails

Equity
last claims on income i.e. after of all creditors have been satisfied last claims on proceeds of sale of assets if firm fails

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3. Maturity
Debt
has fixed maturity period require repayment of principal on maturity

Equity
permanent form of financing does not require repayment of principal liquidated only during bankruptcy proceedings.

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4. Tax Treatment
Debt
interest payments are tax-deductible tax deduction expenses will lower the firms taxes thus, cost of debt financing is lower

Equity
dividends payments are not tax-deductible thus, firms taxes are not lower therefore, cost of equity financing is higher

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1. Equity Financing
Equities are sold (issued) by a company either: 1. at the formation of the company 2. when additional financing are needed. Equities are issued in the Primary Market by the company and resold by the Equities holders in the Secondary Market.
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A. Common Stock
Features of Common Stock
represents ownership, the holders are the true owner of the company no maturity date, but exists as long as the company does stockholders have the residual claim on the firms income and assets

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Features of Common Stock (cont)

stockholders receive variable returns in the 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, limited liabilities

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B. Preferred/Preference Stock
Features of Preferred Stock
a hybrid of common stock and bond. has no maturity date has a par value of usually RM100 per share stockholders receive fixed amount of dividends every year

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Features of Preferred Stock (cont)

stockholders have no voting rights stockholders get claims on profits and assets after bondholders but before common stockholders sometimes carry special features such as callable, cumulative, participative and convertibility.

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2. Debt/Bonds Financing
Features of Debt/Bonds
debt/bond is a long-term debt instrument issued by a firm holders are promised a fixed amount of interest every year until maturity period interest rate also known as coupon rate and thus interest amount is calculated as the coupon rate percentage of the par value par value or face value of bond is normally RM 1000
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Features of Debt/Bonds (cont)

maturity period is between 10 to 30 years issuer (firm) also pays the holders principal payment (par value) at maturity period holders are considered as creditors to firm holders have no voting rights holders 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 to calculate its cost The cost must always be stated on an aftertax basis because the cost of financing to the firm is a return to the providers of the capital and providers will get their returns only after firm pays taxes. Apart from cost of paying providers of funds, firm also incurred flotation costs total costs of selling and issuing securities
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1. The Cost of Common Stock Equity

Two different ways to estimate the cost of common 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 is based on the present value of all future dividends.

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The Cost of Common Stock Equity (cont.)

Constant growth (Gordon) model:

Where

= cost of common stock = expected dividend = market price of stock = constant growth in dividend
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The Cost of Common Stock (cont.)

Using Constant Dividend Growth Model
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%.

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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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The Cost of Common Stock (cont.)

Using CAPM Approach
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%.

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The Cost of Common Stock (cont.)

The CAPM differs from dividend valuation models in that it explicitly considers the firms risk as reflected in beta. On the other hand, the dividend valuation model does not explicitly consider risk. Dividend valuation models use the market price (P0) as a reflection of the expected risk-return preference of investors in the marketplace.
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The Cost of Common Stock (cont.)

Although both are theoretically equivalent, dividend valuation models are often preferred because the data required are more readily available. The two methods also differ in that the dividend valuation models (unlike the CAPM) can easily be adjusted for flotation costs when estimating the cost of new equity.

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The Cost of Common Stock (cont.)

Cost of Retained Earnings (kE) - Cost of retained earnings to the firm is the same as the cost of an equivalent fully subscribed issue of additional common stock - it means cost of retained earnings equal to cost of common stock equity Dr. Mazila Md Yusuf Long-term Financing 26

The Cost of Common Stock (cont.)

Cost of New Equity (kn)
Using Constant Dividend Growth Model

Continuing with the previous example, how much would it 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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2. The Cost of Preferred Stock

Note: Net Proceed = Market Price Flotation Cost 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%

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3. The Cost of Long-Term Debt/Bond (cont.)

Since the cost must be on after-tax costs, the cost of bonds/debt must first calculate the Before-Tax Cost of Bonds/Debt The before-tax cost of debt can be calculated in any one of three ways: 1. Using cost quotations 2. Calculating the cost 3. Approximating the cost

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The Cost of Long-Term Debt/Bond (cont.)

Before-Tax Cost of Debt

1. Using Cost Quotations; that is based the 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 coupon interest rate.
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The Cost of Long-Term Debt/Bond (cont.)

b. A second cost quotation that is sometimes used is the yield-tomaturity (YTM) on a similar risk bond.

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The Cost of Long-Term Debt/Bond (cont.)

Before-Tax Cost of Debt
2. Calculating the Cost This approach finds the before-tax cost of debt by calculating the internal rate of return (IRR), i.e. the actual costs to the firm for having the bonds financing IRR can be calculated using: (a) trial and error, (b) a financial calculator, or (c) a spreadsheet.
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The Cost of Long-Term Debt/Bond (cont.)

Before-Tax Cost of Debt
Approximating the Cost using an equation

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The Cost of Long-Term Debt/Bond (cont.)

Example : Duchess Corporation, a major hardware manufacturer, is contemplating selling $10 million worth of 20-year, 9% coupon bonds with a par value of $1000. Because current market interest rates are greater than 9%, the firm must sell the bonds at $980. Flotation cost are 2% or $20. The net proceeds to the firm for each bond is therefore $960 ($980 - $20).
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The Cost of Long-Term Debt/Bond (cont.)

Before-Tax Cost of Debt
Approximating the Cost

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The Cost of Long-Term Debt/Bond (cont.)

The after-tax cost of bonds/debt:

Find the after-tax cost of debt for Duchess assuming it has a 40% tax rate: = 9.4% (1-.40) = 5.6% This suggests that the after-tax cost of raising debt capital for Duchess is 5.6%.
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Weighted Average Cost of Capital (WACC)

When firm has a mixture of capital as the sources of its LT financing, how much would its overall cost of capital be? The overall cost is known as weighted average cost of capital (WACC) Why?
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The Weighted Average Cost of Capital (cont)

WACC reflects the expected average future cost of funds over the long-run WACC is found by weighting the cost of each specific type of capital by its proportion in the firms capital structure. In equation, WACC can be written as:

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WACC Equation

ka (wi * ki ) (wp * k p ) (wc * kc )

where wi = proportion of long-term debt in capital structure w p = proportion of preferred stock in capital structure wc = proportion of common stock equity in capital structure wi wp wc = 1.0
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The Weighted Average Cost of Capital (cont)

Determine Capital Structure Weights
One method uses book values from 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.
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The Weighted Average Cost of Capital (cont)

Capital Structure Weights
A second method uses the market values of the firms debt and equity. To find the market value proportion of debt, simply multiply the price of the firms bonds by the number outstanding. 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.

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The Weighted Average Cost of Capital (cont)

Capital Structure Weights
Finally, add together the total market value of the firms equity to the total market value of the firms debt. This

yields 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 .
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The Weighted Average Cost of Capital (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 $10 million, 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.

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The Weighted Average Cost of Capital (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 to fund any anticipated investment projects.

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