Equity and Debt - Essay Example

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There are distinct advantages and disadvantages for management to consider when choosing between debt and equity financing of general corporate purposes and to increase its manufacturing capacity. Before moving forward with either option, management needs to fully understand both the benefits and the drawbacks of each potential decision in order to best represent the shareholders of the company…
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Download file to see previous pages However, this is balanced by the requirements of the debt covenant to regularly service that debt; that is, the company regularly needs to make payments to the issuer of the debt to cover the principle they borrowed and the interest required by the debt covenant. This detriment is offset in some regard through the reduction in tax liability (Seidman, 2005) – in short, the payment of debt reduces the amount of income that the company is taxed upon. Equity financing carries with it its own distinct set of advantages and disadvantages. Chief among the advantages of equity financing is the existence of no repayment period of the capital used to expand the business (Seidman, 2005). Since the capital is raised through individuals or businesses buying a share of both the company and its future earnings, the rewards for providing the capital come through an expected increase in the value of their investment. This, however, translates into a disadvantage of equity financing. Namely, while profits are expected to increase, the “pie” is now being divided into more pieces, thus reducing the value of the existing stakes. Further, with the issuance (or release) of additional stock into the market to support an equity financing endeavor, the company becomes more susceptible to outside influences, whether through potential takeovers or through some loss of control of the decision-making process (Seidman, 2005). I neither fully agree nor fully disagree with management’s decision to proceed with equity financing instead of the intended debt financing in the expansion of their manufacturing capabilities. Equity financing makes sense, especially in light of the 305% rise in the company’s stock price over the past year (American Superconductor, 2003). Management is able to take advantage of the ability to raise capital with less dilution of current stockholders’ shares than would otherwise be expected in an environment of stable share price. Debt financing, too, makes sense in regard to the fact that with the government project becoming profitable a quarter ahead of expectations and with the massive savings in operating expenses, debt financing would have been rather easy to service (American Superconductor, 2003). Using that approach, no dilution of stockholder value would be necessary and there would be no potential for a loss of corporate autonomy. Further, with an eye again to lower future operating costs and an unexpectedly profitable revenue stream, debt financing would have lowered the potential future tax burden that the company will soon be faced with. Instead of management undertaking either approach, I believe that a third option would be best. With the company’s results that lent themselves to support debt financing as well as a nearly doubling of revenue company-wide over the past year, management could have funded the entire endeavor through retained earnings had the expansion decision been put off for a short period of time (American Superconductor, 2003). This approach would prevent any dilution of share value, any potential loss of autonomy, and would avoid the seemingly unnecessary burden of additional indebtiture at a time when the company is flush with cash. Having made the decision to raise the capital through equity financing, management needs to determine what the cost of equity truly would ...Download file to see next pagesRead More
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