Assignment on

Long Term financing

COURSE TITTLE: Advanced Corporate Finance

Course Code: 5203
SUBMITTED TO,
Rabeya khatun Taniya
Assistant professor
Department of Accounting & Information Systems
Jahangirnagar University, Savar, Dhaka 1342.

SUBMITTED by,

Group 2: Accountancy
Department: Accounting & Information Systems
Batch: 4th
Jahangirnagar University, Savar, Dhaka 1342.

Submission Date: January 7, 2020

 Group Member’s
Serial No. NAME MBA ID

01 Nasrin Akter(Group leader) 1767

Mail:
nasrinakther372@gmail.com
02 Umme Habiba Champa 1772

03. Bithika Sarkar 1777

04 Md. Hafizur Rahman 1781

05 Md Nazmul sakib islam 1782

06. Murshed Alam 1789

07. Md. Amdadul Haq. 1790
08. Md Faysal Ahshan sajib 1793
 LETTER OF TRANSMITTAL
January 7, 2020
Rabeya Khatun Taniya
Course Instructor,
Jahangirnagar university, Savar, Dhaka

Subject: Submission of assignment on “Long term Financing”.

Sir,
We have the pleasure in submitting the assignment on “” to you. We have tried to express
all the necessary information of this topics and follow your instructions. We are also try all
any kinds of information submitted on this assignment. We are searching the internet web
site & books to prepare on this assignment but no more information on this topic. Thus
next, the final assignment is submitted to you.
We are grateful to you, as you allowed us to perform the study and to submit the term
paper. We hope that the assignment will meet the standard and will serve its purpose.

Thank you.
Sincerely,

……………………………
Nasrin Akter (Group Leader)
ID: 1767
Department of Accounting & Information Systems.
Jahangirnagar University
 ACKNOWLEDGEMENT

All the praise is for Allah, the most merciful and beneficent, who blesses us with the
knowledge, gave us the courage and allowed us to accomplish this task.
As our assigned topic was to prepare an assignment on “Long term Financing” for our
course of MBA program, we collected information from websites and gathering knowledge
in all members to complete our assignment and it’s really a great opportunity for us to
acquire valuable knowledge for this interesting subject. At the very beginning, we want to
express our profound gratitude to our respected course instructor.
Advanced Corporate Finance to provide us with such a nice opportunity to prepare this
kind of a report on We would also like to take this opportunity to express our wholehearted
gratitude to our fellow friends who offered encouragement, information, inspiration and
assistance during the course of preparing this assignment.
.
 Table of Contents

Serial Contents
no.
1 Executive Summary
2 Introduction
3 long term finance
4 Long term financing method

5 Sources of Long Term Financing

o Equity
o Bonds
o Term Loans
o Internal Accruals
o Venture Capital

6 Features of Long Term Bonds

7 Short Term Vs Long Term Finance
8 Importance of long-term financing
9 Types of financial decisions of long term financing
10 Capital market of long term financing
11 Factors Affecting Capital Budgeting (Long Term Investment)
Decisions
12 Working Capital Financing
13 Types of Working Capital Financing / Loans

14 Advantages & Disadvantages of Long-Term Debt Financing

15 Policy challenges
16 Conclusion
 Executive summary:
This assignment aims to enhances the leaders understanding of Long Term Financing.
This will be achieved through defining what it is and what is entails: documenting
 To discuss the about long term financing

 To identify the Long term financing method

To Source of Long Term Financing?

 To Feature of Long Term Bonds, pros and cons of the financing,
 Short Term Vs Long Term Finance
o Importance of long-term financing
 Types of financial decisions of long term financing
o Capital market of long term financing
 Factors Affecting Capital Budgeting (Long Term Investment) Decisions
o Working Capital Financing
o Types of Working Capital Financing / Loans
 Advantages &Disadvantages of Long-Term Debt Financing
 Policy challenges
The key aspects of financial decision-making relate to financing, investment, dividends
and working capital management. Decision making helps to utilize the available resources
for achieving the objectives of the organization, unless minimum financial performance
levels are achieved, it is impossible for a business enterprise to survive over time.
Therefore, financial management basically provides a conceptual and analytical framework
for financial decision making.
The capital asset pricing model (CAPM) and discounted cash flow method (DCF) will be
compared. The debt and equity mix help a company optimize its wealth. The debt and
equity mix will be examined along with characteristics of the financial market, and debt
and equity instruments. Finally, long-term finance alternatives such as stocks, bonds, and
leases are discussed
 Introduction
Long-term financing strategies help ensure that the money invested today will earn more
than or equal to the amount invested. Long-term finance can be defined as any financial
instrument with maturity exceeding one year (such as bank loans, bonds, leasing and other
forms of debt finance), and public and private equity instruments. Maturity refers to the
length of time between origination of a financial claim (loan, bond, or other financial
instrument) and the final payment date, at which point the remaining principal and interest
are due to be paid. Equity, which has no final repayment date of a principal, can be seen as
an instrument with nonfinite maturity. The one-year cut-off maturity corresponds to the
definition of fixed investment in national accounts. The Group of 20, by comparison, uses
a maturity of five years more adapted to investment horizons in financial markets.
Depending on data availability and the focus, the report uses one of these two definitions
to characterize the extent of long-term finance. The use a specific definition of long-term
finance, the report provides granular data showing as many maturity buckets and
comparisons as possible.
The key aspects of financial decision-making relate to financing, investment, dividends
and working capital management. Decision making helps to utilize the available resources
for achieving the objectives of the organization, unless minimum financial performance
levels are achieved, it is impossible for a business enterprise to survive over time.
Therefore, financial management basically provides a conceptual and analytical framework
for financial decision making.
The capital asset pricing model (CAPM) and discounted cash flow method (DCF) will be
compared. The debt and equity mix help a company optimize its wealth. The debt and equity
mix will be examined along with characteristics of the financial market, and debt and equity
instruments. Finally, long-term finance alternatives such as stocks, bonds, and leases are
discussed. Capital asset pricing model vs. discounted cash flow method. Two methods can
be used to calculate the required return on common stock. The first method is capital asset
pricing model, or CAPM. In CAPM, the required return on common stock is reached by
adding the risk-free rate of return to historical validity of the return. The historical validity
of the return is calculated by subtracting the return in the market from the risk-free rate of
return. The discounted cash flow method, or DCF, "uses future free cash flow projections
and discounts them (most often using the weighted average cost of capital) to arrive at a
present value, which is used to evaluate the potential for investment. A good opportunity
exists when the potential for investment is greater than the current cost. The DCF method
is used to account for the time value of money, this means the value of a dollar today has a
lesser value in the future, all else being equal. The following chart shows how the two
methods are calculated and what drawbacks may exist. Description Formula Drawbacks
Capital Asset Pricing Model (CAPM) "CAPM relates the risk-return trade-offs of individual
assets to market returns," (Block & Hirt, 2005). Kj = + Km + e • Kj = Return on individual
common stock of a company • = Alpha, the intercept on the y-axis • = Beta, the
coefficient • Km = Return on the stock market (an index of stock returns is used, usually
the Standard & Poor's 500 Index) • e = Error term of the regression equation CAPM does
not measure all types of assets easily. Discounted Cash Flow Method (DCF) DCF uses future
cash flow and discounts it to get the present value. CF1 CF2 CFn DCF = -------- + -------- +
…------ (1 + r)1 (1 + r)2 (1 + r)n CF = Cash Flow r = discount rate (WACC) The DCF
method should not be used for long-term investing because the estimated value is difficult to
predict as time increases. Debt and Equity Mix.
It can be said that one of the main strives for a company or firm is to maximize wealth. In
order for the firm or company to maximize wealth, it must gain capital by diversifying its
financial portfolio. Few of several ways to diversify the financial portfolio is through the sale
of products or goods, the purchasing of equipment, financing or through investments. A
company's financial portfolio must be carefully projected in a way so the firm is guaranteed
gained capital.
 What is long term finance?
Long-term finance is any financial instrument with a maturity exceeding one year (eg;
bank loans, leasing, bonds, etc)

The funds which are not paid back within a period of less than a year are referred to as long
term finance. Certain long term finance options directly form a part of the permanent
capital of the firm. In such cases, the repayment obligation does not even arise. A 20-year
mortgage or 10-year treasury bills are examples of long term finance. The primary purpose
of obtaining long-term funds is to finance capital projects and carrying out operations on
an expansionary scale. Such funds are normally invested into avenues from which greater
economic benefits are expected to arise in future.

Long term financing method

Once an Investment project has been strategically selected, the next important step is to
decide how to finance the project. The organization may finance the project by using a
Long term or Short term financing methods such as borrowing a bank loan, using its own
capital reserves, issuing bonds, etc. Hence it is important to identify the main types of long
term financing methods.

The capital asset pricing model (CAPM) and discounted cash flow method (DCF) will be
compared. The debt and equity mix help a company optimize its wealth. The debt and equity
mix will be examined along with characteristics of the financial market, and debt and equity
instruments. Finally, long-term finance alternatives such as stocks, bonds, and leases are
discussed. Capital asset pricing model vs. discounted cash flow method. Two methods can
be used to calculate the required return on common stock. The first method is capital asset
pricing model, or CAPM. In CAPM, the required return on common stock is reached by
adding the risk-free rate of return to historical validity of the return.

Discounted Cash Flow Method and the CAPM

The Discounted Cash Flow Method of Valuation and the CAPM

We are going to describe the Discounted Cash Flow Method of valuation in detail. Also in
this post, I am only going to bring up the Capital Asset Pricing Model as an equation. I will
try to bring together the bits and pieces of this formula in our assignment.

Discounted Cash Flow Method

The discounted cash flow method as mentioned earlier essentially discounts all expected
future cash flows of the firm (or equity holders) at a discount rate to obtain a present value
of the firm (or equity).
What Discount rate should you use?
Depending on what cash flows you want to discount, the discount rate will have to be
adjusted. For instance, if you are discounting cash flows to equity, then you should use the
Return on Equity as the discount rate. On the other hand, if you are using cash flows to the
firm (Equity and Debt Holders), then you must use the WACC or Weighted Average Cost
of Capital as your discount rate.

The Capital Asset Pricing Model (CAPM)

The CAPM essentially measures the required return of an asset if that asset was part of a
well-diversified portfolio of an investor. The key word here is “diversified”, which simply
means that the investor has invested across a number of securities – maintaining a
diversified portfolio. When calculating the Required Rate of Equity, therefore, keep in
mind that the number you arrive at does not reflect the required rate of return for an investor
who holds a single stock in his portfolio!
For our purposes, we use the CAPM to calculate the required rate of return (discount rate)
for the equity holders within the firm.
The CAPM equation can be written as follows:

Re = Rf + B(Rm - Rf)

Rf – Risk free rate

B – Beta of volatility of security returns in comparison to the market, also a measure of
systematic risk of a firm as compared to the overall market
Rm – Returns on the market index (such as S&P 500)
We are going to end the blog assignment here at this point as we only wanted to introduce
the CAPM formula in this assignment. In our assignment, we will start breaking down the
CAPM formula and explain the significance and how to derive each of each of the inputs
to the equation.
 Sources of Long Term Financing
Firms use different types of long term financing sources to meet their long term funding
needs. These long term funding methods can be categorized into 3 categories

1- Long Term Debt

2- Preferred Stock
3- Common Stock

1- Long Term Debt

Long Term Debt is any amount of outstanding debt of a company that has a maturity
exceeding one year. Long Term Debts are referred to as Fixed income securities since the
holder of this security receives a constant amount of interest payment over time and have
a fixed claim on the assets of the firm at the time of a bankruptcy.

There are many Sources of Long Term Finance:

The nature of such finance can be ownership as well as borrowing or a hybrid of the two.
Some of the main sources of long term finance are listed below

EQUITY: Equity is the foremost requirement at the time of floatation of any company.
They represent the ownership funds of the company and are permanent to the capital
structure of the firm. The equity can be private or public. Private equity is raised from
institutional or high net worth individuals. Public equity is raised by issuing shares to the
public at large which are subscribed to by retail investors, mutual funds, banks and a pool
of other investors. On the flipside, equity is an expensive variant of long term finance. The
investors expect a high return due to the extent of risk involved.

 Pro: No repayment obligation arises during the lifetime of the company.

 Con: Issue of shares via an IPO in the primary market is a costly affair and entails several
legal and banking expenses.
 BONDS

Bonds are debt instruments involving two parties- the borrower and the lender. The
borrower can be the government, a local body or a corporation. They provide fixed interest
payments at periodic intervals and are redeemable at a predetermined date in future. Bonds
are normally issued against collateral and are therefore a highly secured form of long term
finance. Bonds may prove to be a very cost effective source of funds in a bullish market.
 Pro: Easier to raise funds via bonds, especially federal bonds since they enjoy complete
investor confidence.
 Con: Subject to interest rate risk. Therefore, the price of bonds will fall with an increase
in prevailing interest rates.

Term Loans
Term loans are borrowings made from banks and financial institutions. Such term loans
may be for the medium to long term with repayment period ranging from 1 to 30
years. Such long term finance is generally procured to fund specific projects
(expansion, diversification, capital expenditure etc) and is, therefore, also known
as project finance. Term loans can be sourced by both small as well as established
businesses. Also, the interest rates are relatively low and are negotiated depending upon
the duration of the loan, nature of security furnished, the risk involved etc.

 Pro: Term loans can be sanctioned immediately within a matter of days depending upon
the financial health of the firm.
 Con: Heavy collaterals are required to be furnished to obtain a term loan. Even then, the
amount of loan disbursed remains a fraction of the asset value.

Internal Accruals
Internal accruals are nothing but the reserve of profits or retention of earnings that the firm
has created over the years. They represent one of the most essential sources of long term
finance since they are not injected into the business from external sources. Rather it is self-
generated and highlights the sustainability and profitability of the entity Also internal
accruals are owner’s funds and therefore create no charge on the assets of the company.

 Pro: The firm incurs absolutely no cost in raising such funds.

 Con: It may be a source of conflict since the shareholders may prefer payout of dividends
rather than a plough back.

Venture Capital
This form of financing has emerged with the growing popularity of start-up culture
worldwide. VC firms invest into companies at their inception or seed stage. They are
constantly on a watch out for firms demonstrating high growth potential. Their investment
takes the form of ownership funds and forms a part of the permanent capital of the firm.
Venture capitalists also have a predetermined exit strategy before they invest. This results
in the target company being listed or a secondary sale to another VC firm.
 Pro: The companies who are yet to establish steady cash flows are not burdened by
any covenants which entail debt financing. There is no repayment obligation until the
firm is profitable.
 Con: Firm ends up losing a significant piece of the ownership pie to such Vc’s.

Mortgage Bonds
Bonds which are secured by the pledge of specific assets or pool of assets (Mostly real-
estate assets) are called mortgage bonds. Mortgage bonds can pay interest in either
monthly, quarterly or semiannual periods.

Debentures
A debenture is an unsecured bond (debt instrument) used by large companies to borrow
funds, at a fixed interest rate.

Convertible Bonds
Convertible Bonds are securities that are convertible into shares at a fixed price, at the
option of the bond holder. This gives the bond holder an opportunity for capital gains and
therefore a lower coupon rate is offered on these bonds.

Zero Coupon Bonds

These bonds pay no interest but are offered at a discount rate below their par values and
hence provide capital appreciation rather than current cash income.

Example: A company can issue a zero coupon bond today for $250 for a $1,000 bond
(i.e. par value), which will mature after 10 years, at which time the bondholder will be
paid $1,000.

Junk Bonds
Junk Bonds are high risk, high yield bonds issued to finance a leveraged buyout or
merger or to finance a troubled company.

Floating Rate Bonds

In Floating Rate Bonds, the interest rate is fixed for a shorter period of time and is
adjusted periodically based on the current market rate.
 Features of Long Term Bonds
Coupon Rate
The interest rate paid on the bond is the coupon rate of a bond. This is expressed as a
percentage of the par value of the bond.

Maturity
Date on which the loan is to be repaid is called the Maturity date. The typical maturity on
a long term debt is about 20 – 30 years.

Par Value
The Par Value generally represents the amount of funds the firm borrows and promises to
repay at a future date. The par value is the face value of the bond.

Call Feature
A call feature is an option that permits the issuing company to redeem or call a bond issue
prior to its maturity date, at a specified price termed the redemption or call price. Generally,
the company must repay the bondholder an amount greater than the par value for the bond
when it is called, which is called a ‘call premium’.

Pros and Cons of Long Term Debt

Pros
 Relatively a low ‘After-Tax Cost’ due to the tax destructibility of interest.
 The ability of the company’s owners to maintain greater control over the firm.
Cons
 Increased financial risk of the company resulting from the use of debt.
 Restrictions placed on the firm by lenders.

2- Preferred Stock
These are the stock that entitles the holder to a fixed dividend, whose payment takes priority
over that of ordinary share dividends.

Characteristics of Preferred Stock

Preferred stock has the characteristics of both equity and a debt instrument, and is generally
considered as a hybrid instrument. Like equity shares preferred stock is part of the
shareholder’s equity and like long term debt, it is considered a fixed income security, as
the preferred shareholders receive a fixed dividend.

Preferred Dividends vs Interest

Preferred dividend cannot be deducted from income for tax purposes while interest
payments are tax deductible. Hence after tax cost of preferred stock is higher than long
term debt, when all other factors are constant. Preferred Stock will cost slightly higher than
long term debt.

Rights of Preferred Stock

1-Priority in Dividends
Preferred shareholders have a priority over equity shareholders with regard to dividends.
If a company is unable to pay dividends to preferred stock holders in a given period of
time, the company is not permitted to pay dividends for the equity shareholders as well.
 2-Priority in Assets
In the event of liquidation, the preferred shareholders have a priority over equity
shareholders in relation to the claims on the firm’s assets.

3-Voting Rights
As a general rule the preferred shareholders do not have voting rights. However, these
rights may be given under special instances such as non-payment of dividends for a specific
time period.

Pros and Cons of Preferred Stock

Pros
 Non Payment of Preferred Dividends does not force a company into bankruptcy like debt.
Cons
 Higher ‘After-tax cost’ compared with long term debt instruments, since dividends cannot
be deducted for income tax purposes.

3- Equity Shares (Common Stocks)

An equity share, commonly referred to as ordinary shares or common stocks, is a form of

corporate equity ownership of a public company.
 Characteristics of Equity Shares
 A firm’s equity shareholders are its true owners. Equity is a residual form of ownership
because equity shareholders are entitled to the earnings and assets only after the claims of
other stakeholders are met.
 Unlike debt and some preferred stock, equity shares have no maturity date.
 Unlike debt and preferred stock, which are fixed income securities, equity shares are
variable securities, as the income depends on the level of earnings of the firm.

Rights of Equity Shares

1-Dividend Rights
The shareholders have the right to share equally on a per share basis in any distribution of
corporate earnings in the form of dividends.

2-Assets Rights
In the event of liquidation, shareholders have the right to assets that remain after the
obligations in relation to government (taxes), employees and debt holders have been met.

3-Voting Rights
Shareholders have the right to vote on matters, such as the selection of board of directors,
who will manage the business.

Pros and Cons of Equity Shares

Pros
 Equity shares doesn’t obligate the firm to make fixed payments to investors because the
dividend payment depends on the profitability and the cash flow position of the firm.
 Equity share carries no fixed maturity date like debt instruments. Therefore the non-
payment of dividends doesn’t force the firm into bankruptcy.
Cons
 The issue of additional shares can dilute the original shareholder’s control over the firm.
 The cost of issuing equity shares to the public is high compared to debt.
 Short Term Vs Long Term Finance

A comparative analysis of short and long term financing will further aid in effectively
grasping the benefits of long term finance. Short and long-term sources of finances cater
to a different set of requirements for different borrowers. The table below illustrates some
points of distinction.
Short-Term Finance Long-Term Finance

Typically repayable within one Have a longer time span varying

Duration year or less. from 1 to 30 years.

Obtained to fund temporary

shortfall in the working capital, Obtained to fund the purchase of
repayment of current liabilities PPE or capital projects on a
Requirements etc. wide scale.

Collaterals are the most primary

Do not create a charge on the condition for the furnishing of
Collaterals assets of the firm. long term finance.

Interest rates are stable and the

terms of the loan offer flexibility
Interest rates are unstable and such as prepayment options, re-
are vulnerable to inflationary negotiation of interests upon
Terms of loan forces. improvement in credit rating etc.

A large volume of funds can be

obtained. However the same is
Used to raise funds in limited restricted to the nature of
Volume of amount since they are repayable securities furnished, the credit
funds in the near future. rating of borrower, etc.

Overdraft, Credit Cards, Line of Leasing, Term Loans, Public

Examples Credit. Deposits, Bonds.
 Importance of long-term financing
Extending the maturity structure of finance is often considered to be at the core of
sustainable financial development. Long-term finance contributes to faster growth,
greater welfare, shared prosperity, and enduring stability in two important ways: by
reducing rollover risks for borrowers, thereby lengthening the horizon of
investments and improving performance, and by increasing the availability of long-
term financial instruments, thereby allowing households and firms to address their
life-cycle challenges.
The term of the financing reflects the risk-sharing contract between providers and
users of finance. Long-term finance shifts risk to the providers because they have
to bear the fluctuations in the probability of default and other changing conditions
in financial markets, such as interest rate risk. Often providers require a premium
as part of the compensation for the higher risk this type of financing implies. On
the other hand, short-term finance shifts risk to users as it forces them to roll over
financing constantly.
The amount of long-term finance that is optimal for the economy as a whole is not
clear. In well-functioning markets, borrowers and lenders will enter short- or long-
term contracts depending on their financing needs and how they agree to share the
risk involved at different maturities. What matters for the economic efficiency of
the financing arrangements is that borrowers have access to financial instruments
that allow them to match the time horizons of their investment opportunities with
the time horizons of their financing, conditional on economic risks and volatility in
the economy (for which long-term financing may provide a partial insurance
mechanism). At the same time, savers would need to be compensated for the extra
risk they might take.
Where it exists, the bulk of long-term finance is provided by banks; use of equity,
including private equity, is limited for firms of all sizes. As financial systems
develop, the maturity of external finance also lengthens. Banks’ share of lending
that is long term increases with a country’s income and the development of banking,
capital markets, and institutional investors. Long-term finance for firms through
issuances of equity, bonds, and syndicated loans has also grown significantly over
the past decades, but only very few large firms access long-term finance through
equity or bond markets.
 Types of financial decisions of long term financing
The key aspects of financial decision-making relate to financing, investment, dividends
and working capital management. Decision making helps to utilize the available resources
for achieving the objectives of the organization, unless minimum financial performance
levels are achieved, it is impossible for a business enterprise to survive over time.
Therefore, financial management basically provides a conceptual and analytical framework
for financial decision making.

1. Financing Decision:
All organizations irrespective of type of business must raise funds to buy the assets
necessary to support operations. Thus financing decisions involves addressing two
questions:

I. How much capital should be raised to fund the firm’s operations

(both existing & proposed?)
II. What is the best mix of financing these investment proposals?

The choice between the use of internal versus external funds, the use of debt versus equity
capital and the use of long-term versus short-term debt depends on type of source, period
of financing, cost of financing and the returns thereby. Prior to deciding a specific source
of finance it is advisable to evaluate advantages and disadvantages of different sources of
finance and its suitability for purpose.

Efforts are made to obtain an optimal financing mix, an optimal financing indicates the
best debt-to-equity ratio for a firm that maximizes its value, in simple words, and the
optimal capital structure for a company is the one which offers a balance between cost and
risk.

Financing decisions are the financial decisions related to raising of finance. It involves
identification of various sources of finance and the quantum of finance to be raised from
long-term and short-term sources.

A firm can raise long term finance either through shareholders’ funds or borrowed capital.

The financial management as part of financing decision, calculates the cost of capital and
the financial risks for various options and then decides the proportion in which the funds
will be raised from shareholders’ funds and borrowed funds. While taking financing
decision following points need to be considered:

(i) While borrowed funds carry interest to be paid irrespective of whether or not a firm
earns profit but the shareholders’ funds do not carry any commitment of returns to be paid.
Shareholders receive dividends when business earns profits.
(ii) Borrowed funds have to be repaid at the end of a fixed period of time and there is
financial risk in case of default in payment but shareholders’ funds are repayable only at
the time of liquidation of business.

(iii) The fixed cost paid on borrowed funds is a business expense, it saves tax leading to
reduced cost of capital whereas the dividends paid on shareholders’ funds is appropriation
of profits thus does not reduce tax liability of business.

(iv) The fund raising exercise involves floatation cost which must be considered while
evaluating different sources.

In order to raise capital with controlled risk and minimum cost of capital a firm must have
a judicious mix of both debt and equity. Therefore, cost of each type of finance is calculated
before taking the financial decision of how much funds to be raised from which source.
This decision determines the overall cost of capital and the financial risk for the enterprise.

Factors Affecting Financing Decision:

From the above discussions, you must have realized that financing decisions are affected
by various factors. Some of the important factors are:

(i) Cost:

Cost of raising funds influence the financing decisions. A prudent financial manager selects
the cheapest sources of finance.

(ii) Risk:

Each source of finance has different degree of risk. Finance manager considers the degree
of risk involved in each source of finance before taking financing decision. For example,
borrowed funds have high risk as compared to equity capital.

(iii) Floatation Costs:

Floatation cost is the cost of raising finance. A finance manager estimates the floatation
cost of various sources and selects the source with least floatation cost. Therefore, higher
the floatation cost less attractive is the source of finance.

(iv) Cash Flow Position of the Business:

A business with strong cash flow position prefers to raise funds from debts as it can easily
pay interest and the principal. Interest is a deductible expense, saves tax liability of the
business making the source of finance cheaper. However, during liquidity crisis business
prefers to raise funds from equity.
(v) Level of Fixed Operating Costs:

Fixed operating costs of a business influence its financing decisions. For a business with
high operating cost, funds must be raised from equity as lower debt financing would be
better. On the other hand, if the operating cost is low, business can afford to pay high fixed
charges therefore, more of debt financing may be preferred.

(vi) Control Considerations:

Financing decisions consider the degree of control the business is willing to dilute. A
company would prefer debt financing if it wants to retain complete control of the business
with existing shareholders. On the other hand, a company willing to lose control will raise
funds from equity.

(vii) State of Capital Markets:

Health of the capital market may also affect the financing decision. During boom period,
investors are ready to invest in equity but during depression investors look for secured
options for investment. Therefore, it is easy for companies to raise funds from equity during
boom period.

2. Investment Decision:

This decision in financial management is concerned with allocation of funds raised from
various sources into acquisition assets or investment in a project. The scope of investment
decision includes allocation of funds towards following areas:

i. Expansion of business
ii. Diversification of business
iii. Productivity improvement
iv. Product improvement
v. Research and Development
vi. Acquisition of assets (tangible and intangible),
vii. Mergers and acquisitions.

Further, Investment decision not only involves allocating capital to long term assets but
also involves decisions of utilizing surplus funds in the business, any idle cash earns no
further interest and therefore not productive. So, it has to be invested in various as
marketable securities such as bonds, deposits that can earn income.

Investment decisions are the financial decisions taken by management to invest funds in
different assets with an aim to earn the highest possible returns for the investors. It involves
evaluating various possible investment opportunities and selecting the best options. The
investment decisions can be long term or short term.
Long Term Investment Decisions:

Long term investment decisions are all such decisions which are related to investing of
funds for a long period of time. They are also called as Capital Budgeting decisions.

The long term investment decisions are related to management of fixed capital. These
decisions involve huge amounts of investments and it is very difficult to reverse such
decisions. Therefore, it is must that such decisions are taken only by those people who have
comprehensive knowledge about the company and its requirements. Any bad decision may
severely damage the financial fortune of the business enterprise.

Most of the investment decisions are uncertain and a complex process as it involves
decisions relating to the investment of current funds for the benefit to be achieved in future.
Therefore, while considering investment proposal it is important to take into consideration
both expected return and the risk involved. Thus, finance department of an organization
has to decide to allocate funds into profitable ventures so that there is safety on investment
and regular returns is possible.

Importance of long term investment decisions:

(i) They directly affect the profitability or earning capacity of the business enterprise.

(ii) They affect the size of assets, scale of operations and competitiveness of business
enterprise.

(iii) They involve huge amounts of investment which remains blocked in the fixed assets
for a long period of time.

(iv) The investments are irreversible except at a huge cost.

Importance of Short Term Investment Decisions:

Short term investment decisions are the decisions related to day to day working of a
business enterprise. They are also called as working capital decisions because they are
related to current assets and current liabilities like management of cash, inventories,
receivable etc. The short term decisions are important for a business enterprise because:

(i) They affect the liquidity and profits earned in the short run.

(ii) Efficient decisions help to maintain sound working capital.

3. Dividend Decision:

Shareholders are the owners and require returns, and how much money to be paid to them
is a crucial decision. Thus payment of dividend is decision involves deciding whether
profits earned by the business should be retained rather than distributed to shareholders in
the form of dividends.

If dividends are too high, the business may be starved of funding to reinvest in growing
revenues and profits further. Keeping this in mind an optimum dividend payout ratio is
calculated by the finance manager that would help the firm to maximize its market value.

Dividend decisions are the financial decisions related to distribution of share of profits
amongst shareholders in the form of dividends. The dividend decision involves deciding
the amount of profit (after tax) to be distributed to the shareholders as dividends and the
amount of profit to be retained in the business for further growth of the business. Dividend
decisions should be taken keeping in view the overall objective of maximizing
shareholders’ wealth.

Factors Affecting Dividend Decisions:

The decision regarding the amount of profits to be distributed as dividends depends on

various factors. Some of the factors may be stated as follows:

(i) Earnings:

Dividends represent the share of profits distributed amongst shareholders. Therefore,

earnings is a major determinant of the decision regarding dividends.

(ii) Stability of Earnings:

A company with stable earnings is not only in a position to declare higher dividends but
also maintain the rate of dividend in the long run. However a company with fluctuating
earnings may declare smaller dividend.

(iii) Stability of Dividends:

In order to maintain dividend per share, a company prefers to declare same rate of
dividends. However the decision to change the rate of dividend can be taken only if there
is increase in the company’s potential to earn profits not only in the current year but also
in the future.
(iv) Growth Opportunities:

The growing companies prefer to retain larger share of profits to finance their investment
requirements. Therefore, the rate of dividend declared by them is smaller as compared to
companies who have achieved certain goals of growth and can share larger share of profits
with shareholders.

(v) Cash Flow Positions:

Dividends involve outflow of cash. A profitable company is in a position to declare

dividends but it may have liquidity problems. As a result of which it may not be in a
position to pay dividends to its shareholders. Therefore, availability of cash also influences
dividend decision.

(vi) Shareholders’ Preference:

Management of a company takes into consideration its shareholders expectations for

dividends and try to take dividend decisions accordingly. For example, a company may
declare higher or stable rate of dividend if it has a large number of shareholders who depend
on dividends as their regular income.

(vii) Taxation Policy:

Dividends are a tax free income for shareholders but the company has to pay tax on share
of profits distributed as dividend. Therefore, the decision regarding the amount of profit to
be distributed as dividends depends on the tax rate. Company would prefer to pay lesser
dividends if tax rate on dividends is high.

(viii) Stock Market Reactions:

The share price is directly related to the rate of dividend declared by the company. Share
prices of a company increase if the company declares higher rate of dividend. Therefore,
the financial management considers the potential effect of dividends on the share prices
before declaring dividends.

(ix) Access to Capital Markets:

Decision regarding amount of dividend to be declared depends on the need of profits to be

retained for future investments. Companies who have easy access to the capital market to
raise funds may not require large amount of profits to be retained and therefore may decide
to declare high dividend rate. On the other hand, small companies who find it difficult to
raise funds from capital markets may decide to share lesser profits with their shareholders.
(x) Legal Constraints:

Every company is required to adhere to the restrictions or provisions laid by the Companies
Act regarding dividend payouts.

(xi) Contractual Constraints:

Sometimes companies are required to enter into contractual agreements with their lenders
with respect to the payment of dividends in future. The dividend decisions need to consider
such restrictions while declaring dividend rate to ensure that terms of loan agreement are
not violated.

4. Working Capital Decisions:

In simple words working capital signifies amount of funds used in its day-to-day trading
operations. Working capital primarily deals with currents assets and current liabilities. In
fact it is calculated as the current assets minus the current liabilities. One of the key
objectives of working capital management is to ensure liquidity position of a firm to avoid
insolvency.

The following are key areas of working capital decisions:

o How much inventory to keep?

o Deciding ratio of cash and credit sales
o Proper management of cash
o Effective administration of bills receivables and payables
o Investment of surplus cash.

The principle of effective working capital management focuses on balancing liquidity and
profitability. The term liquidity implies the ability of the firm to meet bills and the firm’s
cash reserves to meet emergencies. Whereas the profitability means the ability of the firm
to obtain highest returns within the funds available. In order to maintain a balance between
profitability and liquidity forecasting of cash flows and managing cash flows is very
important.

Factors Affecting Capital Budgeting (Long Term Investment) Decisions:

While taking a capital budgeting decision, a business has to evaluate the various options
available and check the viability and feasibility of the available options. The various factors
which affect capital budgeting decisions are:

(i) Cash Flow of the Project- Before considering an investment option, business must
carefully analyses the net cash flows expected from the investment during the life of the
investment. Investment should be done only if the net cash flows are more than the funds
invested.
(ii) The Rate of Return- The rate of return is the most important factor while taking an
investment decision. The investment must be done in the projects which earn the higher
rate of return provided the level of risk is same.

(iii) The Investment Criteria Involved- Before taking decision, each investment
opportunity must be compared by using the various capital budgeting techniques. These
techniques involve calculation of rate of return, cash flows during the life of investment,
cost of capital etc.

Examples of capital budgeting decisions:

(i) Investment in plant and machinery

(ii) Purchase or takeover of an existing business firm

(iii) Starting a new factory or sales office

(iv) Introducing new product line

Capital market of long term financing

A capital market is a market where both government and companies raise long term funds
to trade securities on the bond and the stock market. It consists of both the primary
market where new issues are distributed among investors, and the secondary
markets where already existent securities are traded. In the capital market, mortgages,
bonds, equities and other such investment funds are traded. The capital market also
facilitates the procedure whereby investors with excess funds can channel them to
investors in deficit.
The capital market provides both overnight and long term funds and uses financial
instruments with long maturity periods. The stock market forms a major portion of the
capital market.

Working Capital Financing

Working capital financing is done by various modes such as trade credit, cash credit/bank
overdraft, working capital loan, purchase of bills/discount of bills, bank guarantee, letter
of credit, factoring, commercial paper, inter-corporate deposits etc.
The arrangement of working capital financing forms a major part of the day to day activities
of a finance manager. It is a very crucial activity and requires continuous attention because
working capital is the money which keeps the day to day business operations smooth.
Without appropriate and sufficient working capital financing, a firm may get into troubles.
Insufficient working capital may result in nonpayment of certain dues on time.
Inappropriate mode of financing would result in loss of interest which directly hits the
profits of the firm.

Types of Working Capital Financing / Loans

Trade Credit
This is simply the credit period which is extended by the creditor of the business. Trade
credit is extended based on the creditworthiness of the firm which is reflected by its earning
records, liquidity position and records of payment.

Cash Credit / Bank Overdraft

Cash credit or bank overdraft is the most useful and appropriate type of working capital
financing extensively used by all small and big businesses. It is a facility offered by
commercial banks whereby the borrower is sanctioned a particular amount which can be
utilized for making his business payments. The borrower has to make sure that he does not
cross the sanctioned limit. The best part is that the interest is charged to the extent the
money is used and not on the sanctioned amount which motivates him to keep depositing
the amount as soon as possible to save on interest cost. Without a doubt, this is a cost-
effective working capital financing.

Working Capital Loans

Working capital loans are as good as term loan for a short period. These loans may be
repaid in installments or a lump sum at the end. The borrower should take such loans for
financing permanent working capital needs. The cost of interest would not allow using such
loans for temporary working capital.

Purchase / Discount of Bills

For a business, it is another good service provided by commercial banks for working capital
financing. Every firm generates bills in the normal course of business while selling goods
to debtors. Ultimately, that bill acts as a document to receive payment from the debtor. The
seller who requires money will approach the bank with that bill and bank will apply the
discount on the total amount of the bill based on the prevailing interest rates and pay the
remaining amount to the seller. On the date of maturity of that bill, the bank will approach
the debtor and collect the money from him.

Bank Guarantee
It is primarily known as non-fund based working capital financing. Bank guarantee is
acquired by a buyer or seller to reduce the risk of loss to the opposite party due to non-
performance of the agreed task which may be repaying the money or providing of some
services etc. A buyer ‘B1’ is buying some products from seller ‘S1’. In this case, ‘B1’ may
acquire a bank guarantee from the bank and give it to ‘S1’ to save him from the risk of
nonpayment. Similarly, if ‘S1’ may acquire a bank guarantee and hand it over to ‘B1’ to
save him from the risk of getting lower quality goods or late delivery of goods etc. In
essence, a bank guarantee is revoked by the holder only in case of non-performance by the
other party. Bank charges some commission for same and may also ask for security.

Letter of Credit
It is also known as non-fund based working capital financing. Letter of credit and bank
guarantee has a very thin line of difference. Bank guarantee is revoked and the bank makes
payment to the holder in case of non-performance of the opposite party whereas, in the
case of a letter of credit, the bank will pay the opposite party as soon as the party performs
as per agreed terms. So, a buyer would buy a letter of credit and send it to the seller. Once
the seller sends the goods as per the agreement, the bank would pay the seller and collects
that money from the buyer.

Factoring
Factoring is an arrangement whereby a business sells all or selected accounts payables to
a third party at a price lower than the realizable value of those accounts. The third party
here is known as the ‘factor’ who provides factoring services to business. The factor would
not only provide financing by purchasing the accounts but also collects the amount from
the debtors. Factoring is of two types – with recourse and without recourse. The credit risk
of nonpayment by the debtor is borne by the business in case of with recourse and it is
borne by the factor in the case of without recourse.
Some other sources of working capital financing used are inter-corporate deposits,
commercial paper, public deposits etc.

Capital Structure
Capital structure is the mix of the long-term sources of funds used by a firm. It is made up
of debt and equity securities and refers to permanent financing of a firm. It is composed of
long-term debt, prefer­ence share capital and shareholders’ funds.
It is essentially concerned with how the firm decides to divide its cash flows into two broad
components, a fixed component that is earmarked to meet the obligations toward debt
capital and a residual component that belongs to equity shareholders.
 Advantages of Long-Term Debt Financing
There are a number of ways to capitalize a business using debt or equity. After their
personal equity contributions, many small-business owners may prefer to utilize some type
of debt to fund the business rather than take on additional investors. When chosen wisely,
long-term debt financing provides a number of advantages to the business and its owner.

Conserves Operational Cash Flow

Most banks provide term loans, a major source of long-term debt for small businesses, for
three- to seven-year terms. Loans guaranteed by the Small Business Administration can
provide terms up to 10 years. When a company uses these funds to make capital
improvements, acquire equipment or purchase supplies, it does not use operational cash
flow. When a company uses long-term debt to fund non-balance sheet assets including
personnel, it essentially leverages its earnings to grow the company.
Provides Leverage for Owner's Equity
A business generates income and net worth for its owners. By using long-term debt, an
owner leverages her personal investment to increase her returns. If an owner contributes
$100,000 in equity and obtains a $200,000 term loan, the company has $300,000 to invest.
If the company generates a net income of $150,000 for the year, the owner's monetary
return would be $50,000 and her return on equity would be 50 percent. If instead, the owner
had contributed $300,000, her return on equity would only be 16.7 percent.
No or Minimal Investor Interference
When a business utilizes long-term debt, the need to pursue equity investment from
potential business partners or investors declines. As long as your loans remain in good
standing, lenders have no say in your business. Investors have rights and decision-making
input and sometimes have plenty to say about how you run the business. With no outside
investors, you avoid this potential interference.
Build Business Credit
If you obtain long-term debt financing, you increase the likelihood of qualifying for
additional debt financing. Even SBA-guaranteed or personally guaranteed loans can help
your business build credit in its own name. If you can build your company's credit, you can
reduce the reliance on your personal credit. This not only helps you personally, but it
increases the value of your business as a sellable asset separate from you.
Additional Advantages
Long-term debt usually has fixed interest rates that translate into consistent monthly
payments and high predictability. This predictability makes it easy to budget the
operational income that you will need to make the payments. In addition, the business can
fully deduct the interest paid on the debt.

Disadvantages of Long-Term Debt Financing

Long-term debt consists of loans and financial obligations lasting over one year. It is
classified as a non-current liability on the company’s balance sheet. In accounting, long-
term debt generally refers to a company’s loans and other liabilities that will not become
due within one year of the balance sheet date.

Long-term debt financing has some disadvantages from the firm’s viewpoint as
follows:

Interest on debt is a permanent burden to the company. The company has to

pay the interest to bondholders or creditors at fixed rate whether it earns a
profit or not. It is legally liable to pay interest on the debt.
A major drawback of long-term debt is that it restricts your monthly cash
flow in the near term. The higher your debt balances, the more you commit
to paying on them each month.
Debt usually has a fixed maturity date. Therefore, the financial officer must
make provision for repayment of debt.
Debt is the riskiest source of long-term financing. The company must pay
interest and principal at the specified time. Non-payment of interest and
principal on time take the company into bankruptcy.
In times of an emergency, the government has to undertake long-term .loans
even though they are at a higher rate of interest. The burden of the public
debt is thus too much increased.

 Debenture indentures may contain restrictive covenants which may

limit the company’s operating flexibility in future.
 Only large-scale, creditworthy firm, whose assets are good for collateral
can raise capital from long-term debt.
 If the government has accumulated large capital through long-term
loans and no real assets exist to pay off such debts, then it resorts to
excessive taxation.
From the investor’s point of view, in general, debt securities offer stable returns. Further,
if the company is liquidated then debenture holders are paid before preferred stockholders
and common stockholders. Bondholders are creditors, however, they do not participate in
any increased earnings the firm may experience. Similarly, they do not get the right to vote.

Policy challenge
Attempts to actively promote long-term finance have proved both challenging and
controversial. The prevalent view is that financial markets in developing economies are
imperfect, resulting in a considerable scarcity of long-term finance, which impedes
investment and growth. Indeed, a significant part of lending by multilateral development
banks (including World Bank Group lending and guarantees) has aimed at compensating
for the perceived lack of long-term credit. At the same time, research shows that weak
institutions, poor contract enforcement, and macroeconomic instability naturally lead to
shorter maturities on financial instruments. Indeed, these shorter maturities are an optimal
response to poorly functioning institutions and property rights systems as well as to
instability.

From this perspective, the policy focus should be on fixing these fundamentals, not on
directly boosting the term-structure of credit. Indeed, some argue that attempts to promote
long-term credit in developing economies without addressing the fundamental institutional
and policy problems have often turned out to be costly for development. For example,
efforts to jump-start long-term credit through development financial institutions in the
1970s and 1980s led to substantial costs for taxpayers and in extreme cases to failures (Siraj
1983; World Bank 1989). In response, the World Bank reduced this type of long-term
lending in the 1990s and the 2000s. On the other hand, well-designed private-public risk-
sharing arrangements – such as Public Private Partnerships for large infrastructure projects,
or credit guarantee schemes – may hold promise for mobilizing financing for long-term
projects, and allow governments to mitigate political and regulatory risks and mobilize
funding for private investment.
 Conclusion
In the beginning, the assignment on long term financing. We are mainly focus on our
assignment about the long term financing, Long term financing method, What are the
Sources of Long Term Financing, Features of Long Term Bonds, pros and cons of the
financing, Short Term Vs Long Term Finance, Importance of long-term financing, Types
of financial decisions of long term financing, Capital market of long term financing,
Factors Affecting Capital Budgeting (Long Term Investment) Decisions, Working Capital
Financing , Types of Working Capital Financing / Loans, Advantages &Disadvantages of
Long-Term Debt Financing .

In their assignment, the key aspects of financial decision-making relate to financing,

investment, dividends and working capital management. Decision making helps to utilize
the available resources for achieving the objectives of the organization, unless minimum
financial performance levels are achieved, it is impossible for a business enterprise to
survive over time. Therefore, financial management basically provides a conceptual and
analytical framework for financial decision making.
The capital asset pricing model (CAPM) and discounted cash flow method (DCF) will be
compared. The debt and equity mix help a company optimize its wealth. The debt and
equity mix will be examined along with characteristics of the financial market, and debt
and equity instruments. Finally, long-term finance alternatives such as stocks, bonds, and
leases are discussed