Sources of Long Term Finance The Sources of Long Term Finance are those sources from where the funds are raised for a longer period of time, usually more than a year. Long term financing is required for modernization, expansion, diversification and development of business operations. Generally, the companies resort to the sources of long-term finance when they have an inadequate cash balance and need capital to carry out its operation for a longer period of time. Objectives of Long-term Financing + To purchase new asset or equipment + To finance the permanent part of the working capital + Toenhance the cash flowin the firm + To invest in R&D operations + To construct or build new construction projects + To develop anew product + Todesign marketing strategies or increase facilities + To expand business operations The long term financing could be done internally, i.e. within the organization or externally, Le. from outside the organization.Cost of Capital: Meaning and Classification Cost of capital refers to the weighted average cost of various capital components, i.e. sources of finance, employed by the firm such as equity, preference or debt. In finer terms, sd by the firm on its vestment projects, to attra its market value. the rate of return that must be rec the firm and to maint The factors which determine the cost of capital are:~ + Source of finance + Corresponding payment for using finance. On raising funds from the market, from various sources, the firm has to pay some additional amount, apart from the principal itself. The additional amount is not! cost of capi lump sum or at periodicintervals. ing but the cost of u: ig the capital, i I which is either pi Classification of Cost of Capital 1. Explicit cost of capital: It is the cost of capital in which firm's cash outflow is oriented towards utilization of capital which is evident, such as payment of dividend to the shareholders, interest to the debenture holders, etc. 2. Implicit cost of capital: It does not involve any cash outflow, but it denotes the opportunity foregone while opting for another alternative opportunity.Weighted Average Cost of Capital (WACC) Weighted average cost of capital is determined by multiplying the cost of each source of capital with its respective proportion in the total capital. Let us understand the concept of weighted average cost of capital with the help of an example. Suppose an organization raises capital by issuing debentures and equity shares. It pays interest on debt capital and dividend on equity capital. When the organization adds the total interest paid on debt jend paid on equity capital, it obtains weighted average cost of capital. An organization requires generating the profit on its various investments equal to the weighted average cost of capital. capital to the total di Weighted average cost of capital can be calculated mathematically by using the following formula Weighted Average Cost of Capital = (Ke * E) + (Kp * P) + (Kp *D) + (Ky* R).Marginal costing and profit planning Abusiness concern exists with the objective of making profits, and profits are the yardstick of its success. Profit planning is therefore a part of operations planning. It is the basis of planning cash, capital expenditure, and pricing. If growth and survival of a business are to be ensured, planning becomes an absolute necessity. Marginal costing assists profit planning through computation of contribution ratio. It enables planning of future operations in such a way as to either maximize profits or maintain specified levels of profits. Normally, profits are affected by several factors such as the volume of sales, marginal cost per unit, total fixed costs, selling price, sales mix, etc. Hence, management can achieve their profit goals by varying one or more of the above variables. Basic marginal costing equations, which are useful in profit planning, are as follows:Modigliani and Miller (MM) Approach ‘Modigliani and Miller approach to capital theory, devised in the 1950s advocates capital structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm ishighly leveraged or has lower debt component, it has no bearing on its market value. Rather, the market value of a firm is dependent on the operating profits of the company. The capital structure of a companys the way a company finances its assets. A company can finance its operations by either equity or different combinations of debt and equity. The capital structure of a company can have a majority of the debt component or a majority of equity or a mix of both debt and equity. Each approach has its own set of advantages and disadvantages. There are various capital structure theories, trying to establish a relationship between the financial leverage of a company (the proportion of debt in the company’s capital structure) with its market value. One such approach is the Modigliani and Miller Approach. MODIGLIANI AND MILLER APPROACH This approach was devised by Modigliani and Miller during 1950s. The fundamentals of Modigliani and Miller Approach resemble that of Net Operating Income Approach. Modigliar ind Miller advocate capital structure irrelevancy theory. Tt suggests that the valuation ofa firm is irrelevant to the capital structure of a company. Whether a fi has lower debt component in the financing mix, it has no bearing on the value of a firm. hy leveraged orNet Operating Income Approach (NOI) According to Net Operating Income Approach which is just opposite to NI approach, the overall cost of capital and value of irm are independent of capital structure decision and change in degree of financial leverage does not bring about any change in value of firm and cost of capital. The Net approach suggest that the market value of the firm is not affected by the capital structure changes and overall cost of capital remains constant like NI approach, itis also based upon certain assumptions which are: + The market capitalizes the value of the firms as a whole. Thus, the split between debt and equity is not important. * The debt capitalization race (Ko) remains constant and there is no corporate tax. Ke = Ko + (Ko + Ki) D/E Where D/E is the debt-equity ratio at market price. The equation 2 states that if Ko and ki are constant, then Ke will rise inearly with leverage. Thus there is no single point or range where the capital structure is optimum. Graphically, it can be representedas follow: