Debt and Equity Financing of General Corporate Purposes - Essay Example

?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. A key advantage of debt financing lies in the balance of control. When taking on additional debt, management and shareholders maintain the same autonomy in making day-to-day decisions as well as determining the overall direction of the company as they possessed prior to the assumption of debt (Seidman, 2005). 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 be. A company’s cost of equity generally can be determined in two distinct ways – the Gordon Growth Model and the Capital Asset Pricing Model. Unlike the Capital Asset Pricing Model, in order to use the Gordon Growth Model a company must be issuing dividends (Elton, Gruber, Brown, & Goetzmann, 2010). The Gordon Growth Model simply states that the required rate of return of equity – commonly referred to as the cost of equity when making management decisions – is equal to the future expected dividend divided by the current stock price of the firm plus the expected growth rate (Elton, et al., 2010). While straightforward on the surface, the Gordon Growth Model contains additional drawbacks. Namely, the model incorporates an expectation that future growth will occur perpetually at a fixed growth rate (Elton, et al., 2010). Significant volatility in either expected growth rate or stock price renders this model ineffective. Further, the model is increasingly sensitive to wild fluctuations when the expected growth rate approaches the cost of equity, thus again limiting the value of the results (Elton, et al., 2010). The Capital Asset Pricing Model (“CAPM”) can be also be used by management to determine the cost of equity financing when undertaking new projects. Instead of being predicated upon the current stock price and expected dividends of a company, however, the CAPM derives the required rate of return of equity through the expected return of the market as a whole and the investment risk of company as it relates to the investment risk of the market as a whole (Elton, et al., 2010). Simply put, when management takes the expected return of the market in excess of the risk-free investment rate (commonly determined by T-Bills), multiplies it by their company’s Beta – the risk coefficient mentioned previously – and adds back the risk-free investment rate, they arrive at a cost of equity financing for their company (Elton, et al., 2010). Even though the CAPM requires both an expected return of the market and a Beta, its use is not restricted by short-term volatility of a stock’s price nor does it require a perpetual, fixed growth rate. These factors make it a superior choice when determining a company’s cost of equity for companies that aren’t well-established, stable companies with a static dividend policy. Had management decided to raise the capital through debt financing, they would have to be aware that a key advantage of using debt financing for company growth, touched upon briefly above, is the tax savings. Service of debt covenants occurs before taxation calculations of revenue, which allows a company to lower their overall potential tax burden (Seidman, 2005). For example, if you assume that a company made had $100 in taxable income and was taxed at a 40% rate, the company would pay $40 in taxes and their net income would be $60. However, if the company was required to pay $30 in taxes over that period, holding all else the same the company would pay $28 in taxes and would have a net income of $42. Net income is therefore decreased by required debt payment multiplied by the quantity of one minus the tax rate instead of by the entire required debt payment, which provides management considerable savings. References American Superconductor switch; Westboro company plans to raise money through a stock offering. (2003 August 26). New York Times. Elton, E. J., Martin, J. G., Brown, S. J., & Goetzmann, W. N. (2010). Hoboken, NJ: John Wiley & Sons, Inc. Seidman, K. F. (2005). Economic Development Finance. Thousand Oaks, CA: Sage Publications, Inc. Read More