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Principles of Finance – Equity + Debt
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American Superconductor is a clean tech firm with 265 employees and operations in Westboro, Wisconsin and Devens, Massachusetts, where it is headquartered. The company is seeking to forgo its debt financing and to turn to equity financing.
As Steve Jefferson wrote in Pacific Business News, “The way money is raised can have an enormous impact on the success of a business”; this is why the decision should be made with a lot of precautions being taken into consideration. As it is already known, each option has its shortcomings as well as its advantages. Below are the advantages and disadvantages of each of the two options.
Equity financing is raising working capital for a firm by obtaining money from investors in exchange for the ownership of a piece of the firm. The investors are mainly family members, friends, wealthy individual investors, and venture capital firms. This is what Gregory J. Yurek is suggesting to be the sole source of financing for AMSC.
A major factor of attraction to equity financing is the fact that the company is not under any obligation to repay the investors. This means that if the firm goes bankrupt it will not owe anything to anybody. There is also no time limit of paying back what the investors invested in the business. If the firm has more equity, it will look more attractive to other investors, as this is a sign that people have faith in the firm’s ability to succeed.
However, equity financing has a major drawback, which is losing a part of ownership rights to the benefit of investors. This may lead to the loss of control over the firm by its directors, and, in many cases, not using the invested capital in a productive way. If there are any dividends paid, they will not be tax deductable.
Debt financing is borrowing working capital from lenders after they reach a mutual agreement on time and interest rate. This is done by using bonds, bills, and notes. Lenders can be individuals; in most cases, though, these are financial institutions like banks. Admittedly, debt financing is a great way of finding capital for the company.
One of the reasons debt financing is attractive is because of its tax deductions advantage. Normally, the interest and principle payments of the loan are classified as business expenses and can thus be deducted from the business income taxes. Another major advantage that makes debt financing a great idea is the fact that the company’s ownership is not affected in any way despite of the amount that is borrowed. The only obligation is to repay the loan after an agreed period of time and at the agreed interest rate.
This can, however, work against the firm if the company is not able to generate enough cas flow by the agreed time to make the repayment possible. An asset put down as collateral may be lost. Huge debts are also not good for the company’s reputation. Each loan the company takes will influence its credit rating. The more debts the company has, the bigger the risk the lender runs and, consequently, the higher the interest rate.
Capital structures and budgeting decision techniques
In order to come up with these decisions, a number of techniques can be used as a means of evaluating the best choice for AMSC.
Capital structure decisions
There are two main theories in capital structure choices - the trade-off theory and the pecking order theory. The trade-off theory suggests that every company has its most favorable debt-equity ratio, which is determined by trading off the benefits of debts against its costs. In our case, the major advantage of debt financing is tax deductibility, since AMSC is not a small firm. Since AMSC is a mature firm with limited investment options and because it has financial distress costs, it should have higher leverage to take the advantage of tax deduction.
The pecking order theory, on the other hand, suggests that actual corporate leverage ratios do not reflect the capital targets but rather the widely observed corporate practice of financing new investment with internal funds, when possible, and issuing debts rather than equity, whenever external funds are required. This is because, according to the pecking order theory, whenever there is a new equity offering, the stock price falls below fair value. Investors rationally interpret a stock value as an overvalue – at least based on the management’s view of the future - and this causes a fall in the stock value.
Capital budgeting decisions
In modern financial theory, the value of an asset is supposed to be equal to the discounted present value of its future cash flow. This means that a firm contemplating to invest in capital projects should do so only if the net present value (NPV) of the firm is positive or zero, and is never supposed to do so if it is negative.
However, surveys show that the internal rate of return has for long been the criterion used by corporate firms to decide on investment projects. Although the two are similar in more than one respect, IRR is a ratio, while NPV is a dollar measure of value added. Using IRR might, in some cases, reduce value by rejecting positive NPV projects.
NPV might be the best idea, considering the fact that it is ideal for large medium firms like AMSC. Another reason is the fact that AMSC is highly leveraged and pays dividends.
Cost of Capital
This refers to the cost of the company’s funds. The cost of debt referrs to the market interest rate that the firm needs to pay on its borrowing. It depends on the general levels of interest rate, the premium, and the firm’s tax rate.
The cost of equity is the required rate of return, which is included in both dividend yield and the appreciation of the price. There are two models for estimating the cost of equity: Capital Asset Pricing Model (CAPM) and dividend discount model.
CAPM is a model that depicts the relation between the risk and the expected return, which is used in pricing of risky securities, where time value of money and risk are the key factors.
Dividend discount modeling, on the other hand, is a procedure of valuing the price of a stock by using predicted dividends and bringing them back to the present value.
If AMSC’s management decides to forgo debt financing and rely fully on equity financing, it could be a good decision, since the company’s assets would not be seized if the company’s ventures prove unsuccessful; the firm would also not owe anybody a dime if it went bankrupt. Also, a big number of investors would enhance the reputation of the firm, since this would show there is a sound plan, which is likely to be successful for a potential investor.
However, the investors would also have a say in the decisions made by the company’s directors and managers. This could loosen the grip of control by the management hence leading the company to unproductive activities. Forgoing debt for equity financing would be a bad idea and will not do the firm much good. Despite all the advantages, being totally dependent on debt financing would be a suicide for the company. Balancing the two methods of financing would be the best option, as it would ensure getting the absolute maximum from both ends.
In order to make this strategy work, capital structure and budgeting techniques need to be applied. In the case of AMSC, the trade-off theory would be the best technique to come up with a capital structure. This technique is the best one of the two because of its debt-equity ratio strategy and its suitability for a company of the AMSC’s size. The best ratio of debt to equity is 2:1. This ratio will ensure that although shares of the company are bought, this will not exceed the scale large enough to take away the control over the company from its directors and managers. This will also ensure that the company enjoys tax deductions to the maximum and that the claim on the firm’s future profits are minimal. It is also necessary to use a model that would come up with a cost of capital for the firm: Capital Asset Pricing Model is the best model to use in this case, mainly because AMSC is not an all equity financing firm. It is also the best valuation model, as it can easily be applied to the most common types of investments.
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