- Define equity and debt financing, and discuss the advantages and disadvantages of each financing approach.
Let’s assume that taking your company public was a smart move: in posing questions like those that we’ve just listed, investors have decided that your business is a good buy. With the influx of investment capital, the little laundry business that you started in your dorm ten years ago has grown into a very large operation with laundries at more than seven hundred colleges all across the country, and you’re opening two or three laundries a week. But there’s still a huge untapped market out there, and you’ve just left a meeting with your board of directors at which it was decided that you’ll seek additional funding for further growth. Everyone agrees that you need about $8 million for the proposed expansion, yet there’s a difference of opinion among your board members on how to go about getting it. You have two options:
- Equity financing: raising the needed capital through the sale of stock
- Debt financing: raising the needed capital by selling bonds
Let’s review some of the basics underlying your options.
If you decide to sell stock to finance your expansion, the proceeds from the sale will increase your stockholders’ equity—the amount invested in the business by its owners (which is the same thing that we called owner’s equity in Chapter 12 “The Role of Accounting in Business”). In general, an increase in stockholders’ equity is good. Your assets—specifically, your cash—will increase because you’ll have more money with which to expand and operate your business (which is also good). But if you sell additional shares of stock, you’ll have more stockholders—a situation that, as we’ll see later, isn’t always good.
The Risk/Reward Trade-Off
To issue additional shares of stock, you’ll need to find buyers interested in purchasing them. You need to ask yourself this question: Why would anyone want to buy stock in your company? Stockholders, as we know, are part owners of the company and, as such, share in the risks and rewards associated with ownership. If your company does well, they may benefit through dividends—distributed earnings—or through appreciation in the value of their stock, or both. If your company does poorly, the value of their stock will probably decline. Because the risk/reward trade-off varies according to the type of stock—common or preferred—we need to know a little more about the difference between the two.
Holders of common stock bear the ultimate rewards and risks of ownership. Depending on the extent of their ownership, they could exercise some control over the corporation. They’re generally entitled to vote on members of the board of directors and other important matters. If the company does well, they benefit more than holders of preferred stock; if it does poorly, they take a harder hit. If it goes out of business, they’re the last to get any money from the sale of what’s left and can in fact lose their investments entirely.
So who would buy common stock? It’s a good option for individuals and institutions that are willing to take an investment roller-coaster ride: for a chance to share in the growth and profits of a company (the ups), they have to be willing to risk losing all or part of their investments (the downs).
Preferred stock is safer, but it doesn’t have the upside potential. Unlike holders of common stock, whose return on investment depends on the company’s performance, preferred shareholders receive a fixed dividend every year. As usual, there are disadvantages and advantages. They don’t usually have voting rights, and unless the company does extremely well, their dividends are limited to the fixed amount. On the other hand, they’re preferred as to dividends: the company can pay no dividends to common shareholders until it’s paid all preferred dividends. If the company goes under, preferred stockholders also get their money back before common shareholders get any of theirs. In many ways, they’re more like creditors than investors in equity: though they can usually count on a fixed, relatively safe income, they have little opportunity to share in a company’s success.
Cumulative and Convertible Preferred Stock
There are a couple of ways to make preferred stock more attractive. With cumulative preferred stock, if a company fails to make a dividend payment to preferred shareholders in a given year, it can pay no common dividends until preferred shareholders have been paid in full for both current and missed dividends. Anyone holding convertible preferred stock may exchange it for common stock. Thus, preferred shareholders can convert to common stock when and if the company’s performance is strong—when its common stock is likely to go up in value.
Now, let’s look at the second option: debt financing—raising capital through the sale of bonds. As with the sale of stock, the sale of bonds will increase your assets (again, specifically your cash) because you’ll receive an inflow of cash (which, as we said, is good). But as we’ll see, your liabilities—your debt to outside parties—will also increase (which is bad). And just as you’ll need to find buyers for your stock, you’ll need to find buyers for your bonds. Again, we need to ask the question: Why would anyone want to buy your company’s bonds?
Your financial projections show that you need $8 million to finance your expansion. If you decide to borrow this much money, you aren’t likely to find one individual or institution that will loan it to you. But if you divided up the $8 million loan into eight thousand smaller loans of $1,000 each, you’d stand a better chance of getting the amount you need. That’s the strategy behind issuing bonds: debt securities that obligate the issuer to make interest payments to bondholders (generally on a periodic basis) and to repay the principal when the bond matures. In other words, a bond is an IOU that pays interest. Like equity investors, bondholders can sell their securities on the financial market.
From the investor’s standpoint, buying bonds is a way to earn a fairly good rate of return on money that he or she doesn’t need for a while. The interest is better than what they’d get on a savings account or in a money market fund. But there is some risk. Investors who are interested in your bonds will assess the financial strength of your company: they want to feel confident that you’ll be able to make your interest payments and pay back the principal when the time comes. They’ll probably rely on data supplied by such bond-rating organizations as Moody’s and Standard & Poor’s, which rate bonds from AAA (highly unlikely to default) to D (in default).
Treasuries and Munis
Remember, too, that if you decide to issue bonds, you’ll be competing with other borrowers, including state and local governments and the federal government. In fact, the U.S. government, which issues bonds through the Treasury Department, is the country’s largest debtor. Treasury bills, for example, mature in one year, Treasury notes in one to ten years, and Treasury bonds in more than ten years. State and local governments issue bonds (often called munis, for “municipals”) to support public services such as schools and roads or special projects. Both treasuries and munis are attractive because the income earned on them is generally tax free at the state and local levels.
Choosing Your Financing Method
Let’s say that after mulling over your money-raising options—equity financing versus debt financing—you decide to recommend to the board that the company issue common stock to finance its expansion. How do you explain your decision? Issuing bonds is an attractive option because it won’t dilute your ownership, but you don’t like the idea of repaying interest-bearing loans: at this point, you’re reluctant to take on any future financial obligation, and money obtained through the sale of stock doesn’t have to be paid back. Granted, adding additional shareholders will force you to relinquish some ownership interest: new shareholders will vote on your board of directors and could have some influence over major decisions. On balance, you prefer the option of selling stock—specifically, common stock. Why not preferred stock? Because it has drawbacks similar to those of debt financing: you’d have to make periodic dividend payments, requiring an outflow of cash. Once the matter has been settled, you take a well-deserved vacation. Unfortunately, you can’t stop thinking about what you’ll do the next time you want to expand. In particular, franchising seems to be a particularly attractive idea. It’s something you’ll need to research when you get a chance.
- Companies can raise funds through equity financing—selling stock—or through debt financing—issuing bonds. Each option has its advantages and disadvantages.
- Stock may be common stock or preferred stock.
- Preferred stock is safer than common stock but it doesn’t have the upside potential—namely, the possibility that shareholders will benefit greatly if a company performs very well.
- Unlike common stockholders, however, whose dividends vary according to a company’s profitability, holders of preferred stock receive annual fixed dividends.
You’ve been out of college for fifteen years, and now you’re the CFO for a large corporation. Your CEO just showed you plans for a multimillion-dollar plant expansion and reminded you that it’s your job to raise the money. You have three choices: sell bonds, issue common stock, or issue preferred stock. Write a brief report that explains the advantages and disadvantages of each option. Conclude by stating your opinion on the best choice in today’s economic environment.