Question

Raising Extra Capital

As companies mature, their business needs change. This typically causes the need to raise extra capital to begin an expansion project. An influx of capital funding may be necessary to construct or purchase a new structure, testing and developing new products, a merger, acquisition, or take over. Nevertheless, the business may seek to acquire capital from ether a debt or equity IPO offering.

• If you owned a large company and needed capital for a major international expansion project would you prefer to do an IPO stock offering or corporate bond offering and why?
• Explain the pros and cons of an IPO stock offering (equity) or corporate bond offering (debt).

Answer 1

The pros of an IPO are :

• Dividend is not required to be paid mandatorily. The decision to pay dividend, and the rate of dividend if it is to be paid, is at the discretion of the board of directors
• Large amounts of capital can be raised as the risk of investment is borne by a large number of investors
• Public awareness of the company is increased

The cons of an IPO are :

• An IPO process involves regulatory hurdles and a lot of paperwork.
• A publicly listed company has a high cost of compliance due to more regulation and rules
• Financial statements are required to be disclosed publicly
• Issuing shares means that management control is diluted since shares carry voting rights

The pros of a bond offering are :

• Easier to do than an IPO in terms of legal and regulatory hurdles
• Bonds do not carry voting rights, hence there is no loss of management control
• There is no requirement to publicly disclose financial statements
• Cost of compliance is relatively less

The cons of a bond offering are:

• Periodic interest is mandatory to pay. Hence, there is a cost of interest, which has to be paid, failing which the company will be deemed to be in default
• It may not raise as much capital as an IPO since higher amounts of debt increase the financial leverage of the company, which is risky to the company and investors

If I were to raise capital for an international expansion project, the source of capital would depend on many factors such as interest rates, amount of capital required, regulatory issues, control of company etc. It cannot be answered without more specific information. However, the general rule is that :

• If interest rates are low, bond offering should be preferred
• If the current stake of the promoter is high enough, then issue of equity shares would not be a major issue because management control can be retained. However if the current promoter stake is low, there would be loss of management control. In such a case, bond offering should be preferred
• There may be specific legal or regulatory requirements which make an IPO or bond offering impossible
• If the amount of capital required is relatively large, IPO should be preferred. However, this depends on specific circumstances