Introduction
Most business enterprises are normally creations of ingenious business minds that make difficult financial decisions in order to take the business to the next level. In most occasions, only businesses with spectacular principles and competitive managers have an edge over competitors thereby staying in a market. An important aspect of a business is its mode of financing which can either be equity or debt business financing. This paper gives a comprehensive discussion on the advantages and disadvantages of both equity and debt as business financing strategies. Additionally, the paper gives a recommendation on the decision of AMSC to settle for equity financing.
Discussion
Advantages and disadvantages of both debt and equity business financing modes
One of the most important benefits for debt financing is that it makes purchase of business assets easy before one can earn any money and the money borrowed is not paid at once hence giving room for more investment. Debt financing also makes an investor enjoy premium ownership of his business.
However, debt business financing also has its setbacks that would have stifled AMSC. This mode of financing would have forced AMSC to pay back loans with interests. Moreover, repossession of assets would have take place AMSC did not comply with loan policies (Harvey, 2002). This mode of financing would have also limited anticipated cash flow because the business would have to set aside money for loan repayment. AMSC could not have invested further because future profits would finance the debt instead of assets. In addition, this would have made it difficult for AMSC to get another loan. This is because banks do not give more loans unless the previous one is settled.
Equity financing is the best form of income generation for AMSC because of no repayment of loans. The absence of repayable loans enables the company to invest more using the profits gotten from sales. AMSC will also uphold a somewhat small debt-to-equity ratio thereby being in a position to acquire a loan. Funding through this scheme also means that assets of the company are not at risk of repossession like experienced in the case of debt financing (Harvey, 2002).
AMSC will, however, experience a few inconveniences after venturing into equity financing. The company will only partially own its assets and in so doing, it will have a constrained influence and decision-making authority over its operations. Subsequently, some portion of the profits realized by AMSC is also shared amongst the equity investors. It is important to note that the company might find out that distributed profits are more than the amount that should have been deposited as loan particularly if there are quite a number of equity owners.
In financial theory, a firm’s cost of equity is a representation of the rate at which a market demands return in relation to possessing the asset and stomaching the risk associated with ownership (Gotthilf, 1997). It is the compensation that could have been earned by investing the same money into a different investment with the same risk. There are two ways to determine the cost of equity of a company. First is the dividend growth model. This model equates the cost of equity (COE) as the summation of the annual dividend of the next year/the total current stock price and the dividend growth rate. The second one is CAPM (Capital Asset Pricing Model) used to find the intended rate of return meant for any risky asset. For example, AMSC could use this model to decide what price should be paid for stock. If stock X is riskier than stock Y then the price of stock X ought to be lower to compensate the investors for investing on the increased risk.
Tax deduction from interest makes debt financing competitive in the market since the cost of capital decreases with the increase in the proportion of debt in the capital structure. Higher rates of taxation in the corporate would most likely call for an increase in investors using debt to finance capital. This is different from using equity issuance. This is because dividend payments are not tax-deductible whereas interest payments are. However, investors must keep in mind that there are different kinds of debt that may have different deductibility and tax implications (Harvey, 2002).
Conclusion
In conclusion, I agree with the decision of AMSC Company to take on equity financing. The company will enjoy the benefits of using capital raised from investors instead of making voluminous loan payments to banking institutions. Subsequently, the business will proceed without any financial saddle.
References
Gotthilf, D. L. (1997). Long-term borrowing techniques. New York. Treasurer's and Controller's Desk Book, American Management Association.
Harvey, C. (2002). How do CFOs make capital structure and budgeting decisions: Journal of Applied Corporate Finance, 15(1), 8-23.
