Question

Discuss the relative costs and benefits or raising new capital through a bond issue and through a stock issue. What issues should the firm consider when deciding how to raise new capital?

Answer 1

Cost and benefits of raising capital through a bond issue

Bonds are issued by companies to raise funds for large scale projects and often to replace finance the firm acquired through banks.They are a very flexible way of raising capital , bonds maybe secured or unsecured.Bonds based on fixed interest rates can offer some level of economic protection compared to the funds raised through sources that charge variable interest rate . Bonds also allow companies to hold on to the cash as the redemption dates are often several years from issue date.They also help prevent dilution of ownership which maybe the case if additional shares are issued instead.Since bonds charge a fixed rate of interest , the interest amount will have to be paid even if the firm inccurs a loss.Certain covenants put in place by the investors to protect their investment, may restrict the business operations of the firm.The firm will have to make information on the company publicly available starting from the issue stage and continue the process throughout the life of the bond

Cost and benefits of stock issue

Firms issue stocks to raise money and every share gives the owner of the share, ownership of the company and benefits like oppurtunity to get dividend on the profits.The best thing about raising money through shares rather than raising money through debt is that the fund raised via shares is not a debt and therefore the firm does not have to worry about treating it as a debt and the fixed cost that come along with it.It also allows the firm to utilize the share sale proceedings according to ther perrogative since is no covenants or other restriction which would have been the case if the fund was raised via bond issue or through debt.The firm can decide on what kind of shares to issue the number of shares to issue and thier price.A major downside to raising capital from issue of shares is the cost involved in raising funds , this occurs once we take into consideration the taxes involved.The corporation can't deduct the amount it spends on paying dividends or in repurchasing shares.Another downside is that shareholders have voting rights and can change the corporate policy.Raising capital via shares aslso opens up the company to the possibility of a hostile takeover.

Things to consider when raising capital

Ultimately the management has to decide on how they want to raise capital,through debt or equity.As mentioned above both ways have their own pros and cons.If the firm decided to raise capital through debt ,the firm must be in a position to bear the fixed costs associated with the funds and also the covenants or other restrictions placed by bondholders or lenders.If the firm decided to go the equity way the firm needs to ensure that takeover defenses are put in place to prevent a hostile take over and deal with the fact that equity dilutes ownership.In most cases firms opt for a combination of both.

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