Debt and Equity Financing-American Superconductor Case
Business financing is the act of seeking financial funding that can support a business as a form of capital. There are many business financing options available to most public companies, but perhaps the most commonly applied financing methods are debt and equity financing. These methods may be used singly or in combinations, but they both have their own advantages and disadvantages. Firstly, debt financing involves the acquisition of finances in form of loans which are invested in the business operations and paid off in installments agreed upon in the loan terms with some percentage of interest.
Debt funding may be long term or short term, long term. Long term debt financing is pain over a number of years whereas; short term debt is paid in less than a year. The only obligation that a business has in debt financed cases is to repay the loan in time. On the other hand, equity financing involves selling out shares to investors who offer their money as capital for investment in the business in return for shares valued at the monetary value contribution to the business’s capital (Houston & Brigham, 2008).
This is simply an exchange of the business’s portion or share of business for the exchange of money in terms of valued share units.AMSC may indeed have some advantages having foregone debt financing because of the inherent challenges found in debt financing that make it a disadvantageous option . Firstly, a 50$ billion debt may be too heavy and it could impair their credit rating, and they may be unable to acquire any more credit soon to finance any emergency requirements. Secondly, such a large debt may require higher interest payments and much of the company’s profits may be swallowed up in the loan repayment, thus making the company not to fully realize the fruits of its labor.
Debt financing would have required the company to go through a lot in trying to show that they have enough cash flow to support loan repayment and it may also have required them to pledge a part of their assets that would finally be seized if they failed to repay the loan-this could lead to bankruptcy eventually (Cox, 2011). Their decision to raise the required capital through the sell of equity was actually prudent, because they may not have to repay their investors when the business fails, and additionally; if the business is to operate as zero profit or loss they do not have to repay their investors interest or nay other form of payment.
There is also no need to pledge any form of collateral and thus there is no fear of losing anything incase the company fails to make profits or runs into losses. Additionally, the company has had good returns with its share value rising to 12.20$, an increase of 60 cents. The 305% percent rise in the share is also likely to attract investors that can fund the business through equity, thus making the search for a loan unnecessary (Esposito, 2003). The momentum of business’ revenue gains has picked and the company is on the right path towards achieving its target, therefore it is able to attract investors and their confidence, and thus making the search for a loan unnecessary. The business is also likely to have more cash in future for any projects because profits can easily be plowed back, unlike in debt financing where the interests consumes a bigger part of the profit.
AMSC will however encounter some disadvantages because it will miss out on the tax deductions offered on loan interests. The tax deductions are provided to businesses that acquire loans to finance their businesses and they are beneficial because they help the firm retain much of its profits (Cox, 2011). The company will also lose part of the control that it has on the company and therefore, it may be forced to act in the interest of the stakeholders who may wield a lot of influence especially, if they hold a large portion of the equity that funds the business (Houston & Brigham, 2008). Another disadvantage is that payments to investors within any corporation are not tax deductible. Conflict of ideas may also potentially arise between the company and investors.
Nevertheless, equity funding was still the best option for the company because it eliminates the risk associated with the need to pay loans whether the company is running at a profit or not.n order to determine a company’s cost of equity the (TSR) total shareholder return should be taken into consideration. Where the calculation goes as followsTSR = (end of period price share-price of share at the onset of period+ dividend earned on share in the designated period)/(price of share at the beginning of the period). The TSR shows what investors anticipate to earn when they purchase shares from the company (Premium Business Training, 2011).
For example if an investor is putting in 200$ in the equity of a company such AMSC today and he is anticipating the share to be worth 300$ by the end of the trading period and he anticipates a dividends of 5$; then the implicit cost of the equity of AMSC will be (300$ + 5$-200$)/100=1.05%Conclusively, both methods have advantages and disadvantages the choice of a method to finance one’s business should depend on the type of business, environment and ability to use any other alternatives. In AMSC’s case it has the ability to use both, however; a new upcoming company may be unable to raise capital through equity because it is least known. But on the other hand, well established companies that are profitable may be able to do so. Therefore, it also depends on the stage, age and profitability of a business. However, many factors have to taken into account when making such a decision.
References
Cox, H. (2011),. Debt versus equity funding, retrieved on 12th March 2011 from http://ezinearticles.com/?Debt-vs-Equity-Funding&id=829120
Esposito, A. (2003),. American Superconductor switch: Westboro Company plans to raise money through a stock offering, Telegram and Gazette, Worcester: MA. Retrieved on 12th March 2011 from
http://140.234.17.9:8080/EPSessionID=252a68c6cfdbd025276518ac566ed7/EPHost=proquest.umi.com/EPPath/pqdweb?did=389852771&Fmt=3&VInst=PROD&VType=PQD&RQT=309&VName=PQD
Houston, F. J. and Brigham, F. E. (2008),. Fundamentals of financial management, 6th edition, Cengage Learning
Premium Business Training (2011),. Cost of equity, retrieved on 12th March 2011 fromhttp://www.premiumbusinesstraining.com/cost_of_equity.php
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