Why AMSC Forgo Debt Finance for Equity Finance
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Debt finance is the capital raised from borrowing and it comes in many forms. Debentures are part of debt finance and they carry a fixed charge which the company (the debtor) that is supposed to pay the debenture holder (creditor). Loans are also part of debt finance and there are two categories: long term loans and short term loans. Any kind of borrowing for later payment including interest is referred to as debt financing (Ashiq, 2006).This paper seeks to address the feasibility of AMSC forgoing debt financing and taking on equity financing
Equity finance, on the other hand, refers to selling of shares to investors who, in turn, will be part of the ownership of the company (Brigham & Houston, 2006). The degree of ownership is proportional to the percentage of shares invested into the company by a shareholder. Equity can also mean the amount of capital raised by a proprietor himself. This is most common in the case of small businesses where the proprietor can use his/her own capital to finance the business. I this case AMSC is a big company and therefore we will rely on the first definition which refers to equity financing as the capital that is raised from shareholders.
In this case, AMSC has made a decision to forgo debt financing and major on equity financing as a strategy. There are some factors that AMSC has to consider about the preference of either debt financing or equity financing. The biggest threat associated with debt financing is repayment which has to be done before any other form of capital and it is fixed regardless of whether the business made profits or losses. Failure to repay can render a company into receivership. That is why many investors consider the gearing level of a company very important in deciding whether to invest in a company’s shares or not (Lawrece, 2007). Even after making tax deductions, the interest paid is still high and, therefore, this could be one of the factors that AMSC considered before making such kind of a decision.
The issue of collateral is also important to be brought to light. It is often required to put an asset of the company as collateral so that in case the company fails to owner its repayment obligation, the collateral will be used to compensate the lender. If the lender requires a significantly huge amount as collateral and the borrower isn’t able to produce, it becomes difficult to obtin debt finance. Bringing in more debt finance is referred to as levering up and it affects a company’s credit rating. The higher the credit rating, the higher the interest rate, and since each time AMSC borrows money, the higher it’s credit rating. I agree with their decision on this argument.
However, there are some benefits also associated to debt financing. Debt financing reduces the risk of the company in losing control of its ownership. Contrary to debt financing, equity financing based on shares reduces the level of ownership and control of the company by allowing ordinary shareholders to participate in the company’s decision making. Debt financing, therefore, saves a company from this problem. Debt financing also benefits the debtor by being tax allowable. The interest is considered as business expense and is tax allowable, therefore, reducing the repayment burden (Brigham &Houston, 2006).
Before making a conclusion whether to support the decision made by AMSC or not, we have to analyze the merits and demerits of equity financing too. Equity finance is easier to raise and, therefore, economical and convenient for a starting company. It carries no interest but involves dividends which are paid last after all other costs of capital are paid. If a company makes no profits, the ordinary shareholders will not be paid and it saves the company from running into receivership. Participation of shareholders in decision making increases the sources of ideas and, due to this fact, the company stands a better chance to make proper decisions. Its demerits are few compared to its merits and include the risk of losing control of the company due to divided ownership (Wachonicz, 2009). If the profits are big, you still have to share according to the percentage of ownership of each shareholder and this could be more money than what the creditors could have required as interest.
According to the above analysis, the drawbacks of debt financing somehow outweigh the benefits, and the merits of equity finance outweigh its demerits. Considering the decision made by AMSC to forgo debt financing and take on equity financing, I tend to think that the drawbacks of debt financing also outweighed its benefits in this company and equity financing became the best option for AMSC. I, therefore, agree with their decision to forgo debt financing and take on equity financing.
Calculation of cost of equity is a bit complex comparing to other costs of capital. This is because the risk factor has to be put into consideration. We have to use the capital asset pricing model to calculate the cost of equity. This formula states that the cost of equity is equal to the risk free rate added to the multiplication of the beta factor by the equity risk premium (Brigham & Houston, 2006). The formula can be illustrated like this:-
Kr = K f + (K m – K f) ß i
Where: Kr is the cost of retained earnings
Km is the required rate of return on the market
Kf is the risk free rate
ßi is the stock's beta coefficient
In the United States of America, the risk free rate of a company is generally considered to be the yield on ten to twenty years of the U.S treasury bond. The equity risk premium is the amount that ordinary shares are supposed to exceed the risk free rate in the long term. Before the credit crises, most banks used an equity premium of about four to five percent, but nowadays it has gone slightly higher.
Our last question is about tax deduction in the use of debt financing. Debt financing yields a cost of capital referred to as interest. According to Brigham & Houston (2006), interest is included in the calculation of a company’s profit or loss as an expense to the company. This is the major reason why interest is tax allowable. Therefore, I conclude by stating that there is a tax deduction on the use of debt financing and this is one of the advantages of debt financing.