University of Phoenix
July 1, 2008
Introduction In this paper team d will compare and contrast the capital asset pricing model and the discounted cash flows model. The paper will also evaluate the debt/equity mix and the dividend policy. In addition, it will describe several characteristics of debt and equity as well as the cost. In closing, the paper will evaluate the various long-term financing alternatives such as bonds, stocks and leases.
Long-Term Financing The capital asset pricing model (CAPM) is “a model that relates the risk-return trade-offs of individual assets to market returns” (Block & Hirt, 2004). The model assumes a “security is presumed to receive a risk-free rate of return plus a premium for risk” (Block & Hirt, 2004). CAPM can be used to calculate the required rate of return on common stock. The CAPM model is a “linear relationship between returns on individual stocks and stock market returns over time (Block & Hirt, 2004). According to our text, “some accept the capital asset pricing model as an important approach to common stock valuation, while others suggest it is not a valid description of how the real world operates” (Block & Hirt, 2004). Block and Hirt state, the theory of CAPM “encompasses all assets, but in practice it is difficult to measure returns on all types of assets or to find an all-encompassing market index” (Block & Hirt, 2004). The discounted cash flows model (DCFM) is a combination of three steps. The first is the “production of forecasted financial statements” (Jennergren, 2006). The second step is “deriving free cash flow from operations from financial statements” (Jennergren, 2006). The third step is “discounting forecasted free cash flow to present value” (Jennergren, 2006). There are several features of DCFM. One feature is that the “model uses published accounting data as input” (Jennergren, 2006). The information from the published data such as historical income statements and balance sheets are used to calculate essential financial ratios. The ratios “are used as a starting point in making predictions for the same ratios in the future years” (Jennergren, 2006). The next feature is “the object of the discounted cash flow model is to value the equity of a going concern” (Jennergren, 2006). The DCFM uses an indirect approach to placing value on assets. In addition, it deducts interest-bearing debt to arrive at equity. An indirect approach is recommended because ‘it leads to greater clarity and fewer errors in the valuation process” (Jennergren, 2006). Another feature of the DCFM is “the value of the asset side is the value of the operations plus excess marketable securities” (Jennergren, 2006).
Debt/Equity Mix The capital budgeting of an organization consists of two components: debt and equity. Lenders and equity holders count on a certain return on the funds they have provided. The cost of debt is measured by the “interest rate, or yield, paid to bondholders” (Block & Hirt, 2005). Prior to issuing new debt, firms calculate the anticipated costs associated with the new debt in the market by tabulating the yield on its currently outstanding debt. The rate used in this calculation is the rate investors are requiring today rather than the rate of the old debt authorized. The investor must be aware of the opportunity costs involved with taking on the risk associated with investing money into a company. The cost of common equity is the annual rate of return an investor estimates to earn when investing in shares of an organization. The rate of return is comprised of the dividends paid on the shares and any increase/decrease in the fair value of the shares. When calculating the costs of common stock, “the firm must be sensitive to the pricing and performance demands of current and future stockholders” (Block &