To start with since investment requires a lot of cash, there are three common ways a corporation may be able to raise this cash: (1) by paying smaller dividends, (2) by borrowing, or (3) by selling more stocks with each method having its advantages and disadvantages. Methods of corporate finance continually evolve as financial managers invent new ways to raise money and avoid risk. Smart investment and financing decisions are crucial to a firm’s success. A company can finance projects by paying smaller dividends.
By paying out less of its profits in dividends, the company can keep more of its profits as retained earnings and use them to fund its investments. Using retained earnings to finance projects appeals to managers of companies because they can avoid paying interest. However, the shareholders may not like it if the dividends become smaller. Also, sometimes the firm needs more money for a particular project than it has available in retained earnings. A company can also choose to borrow money to fund its projects.
A firm can either borrow from a bank or directly from investors by issuing bonds. Although it is essential for a firm to an pay interest if it borrows money, it can deduct the interest from its profits and therefore pay less in taxes. However, there are limits to how much a firm can borrow and too much borrowing could lead to bankruptcy. When one therefore considers the decision made by AMSC,an America superconductor company, it is meant to safeguard against the problem of bankruptcy in which debt financing is largely associated with.
A major advantage of equity finance over debt finance is therefore that of lofty interest payable on the amount borrowed. Selling stock is a veritable means in which companies can raise funds. This choice has been considered in the case of America superconductor company as “They scuttle plan for a 50 million dollars secured debt financing and instead will raise funds by public stock offer (Andy,2003). They were to disclose :1) the amount of shares to be sold 2) amount of expected proceeds and names of underwriters in a securities and excellent commission registration statement.
The decision may be justified as there has been a remarkable improvement in the company’s revenue as they target a range of 45 to 50 million dollars which was a double of that for the 2003 fiscal year. Unlike a loan, the funds received from the sale of stocks belong to the AMSC and do not have to be repaid. As a consequence, the firm does not have the expense of paying interest. However, the firm must still earn a certain return on its investment to obtain the cash to pay dividends or devote to retained earnings but this is only compulsory in a profitable year.
Some businesses also may not want to issue stock because the costs of issuing stock, such as fees for legal and banking services, are usually higher than for issuing bonds. The AMSC’s cash reserves would also necessitate a justifiable equity fund raising approach as the cash reserves of the company was not up to the company’s projected spending ( $12million cash reserves compared to the estimated spending of $13-$15 million for that year). A financial manager would want to consider factors other than cost when deciding how to raise money.
For example, if a firm tries to raise new funds, the public will speculate about the company’s plans. If investors think the plans are a bad idea the company’s stock price could fall. In the case of the AMSC, the decision was supported by the shareholders of the company and this is a good prognosis. One major disadvantage to equity financing arise here in that there is the adulteration of the AMSC ownership interests and the possibility of loss of control that may accompany a sharing of ownership with the investors .
The AMSC as a company have gotten a positive business antecedent for themselves in that the company’s product are doing well in the market and meeting the demands of the public and also there has been a kind of premature profit profile in one of the branches of the company as they make tremendous profit a quarter ahead of the expected time. All these would further enhance public trust and clear the public minds of speculation and will also improve the prognosis of the sellability of the shares.
The spirit behind the issuance of the public offer is well justified as “AMSC needed the money for general corporate purposes and to scale up manufacturing at Devens of its second-generation high temperature superconductor wire” (Andy, 2003). In general some other advantages of equity include the fact that the investors cannot force the AMSC to pay return(dividends) as this can only be paid at the year the company makes profit and could be avoided if a loss is made.
Equity financing could also serve like a magnet that brings opportunities in form of contacts, expertise and versatility to the company. On the contrary, it could have some demerits in that the interference of shareholders could affect the company’s decision. Also ,equity financing could be expensive and it also takes a lot of time and it involves compliance with a lot of legal issues.
Andi, E. (2003). American Superconductor switch; Westboro company plans to raise money through a stock offering.
Retrieved on Oct. 8, 2008 from http://proquest. umi. com/pqdweb? did=389852771&sid=5&Fmt=3&clientId=29440&RQT=309&VName=PQD Business Link: “Equity Finance”. Retrieved On oct. 10, 2008 from http://www. businesslink. gov. uk/bdotg/action/layer? topicId=1073864776 Lim, A. (2008, June 21). Home Equity Loan – Advantages and Disadvantages. Retrieved October 10, 2008, from http://ezinearticles. com/? Home-Equity-Loan—Advantages-and-Disadvantages