Question

Compare and contrast new debt offerings to new offerings of equity in the form of stock. Specifically, be sure to comment on the direct and indirect costs of new public debt versus new public equity.

Answer 1

Issue of Equity or Debt are commonly used methods for business financing.  

Buyer's of the Comany's Debt instruments have no claim to ownership in the business. This prevents dilution of the Company's ownership. The holder of the debt instrument is akin to a lender being entitled to principal / face value / base value and interest payments on the said amount at the specified rate.  The holder of the debt instrument in the Company has no right to the future profits of the Company. However, due to the fixed nature of the returns on these instruments, risk borne by the holder is low. Hence, the Cost of Debt Capital is also lower than Equity Capital.

Issue of New Equity dilutes the existing ownership interest of the Company. In most cases it also increases the shareholder base (number of shareholders) of the Company. The major disadvantage is the possibility of future loss of control and decision making power (if issued to large investors). However, the Company is not obligated to make payments of interest regularly as in the case of Debt Instruments. This in turn preserves the cash flow of the Company and makes profits available for reinvestment into the business. Equity holders take on more risk; due to the uncertainty of business success and growth leading to uncertainty of cash inflows. This is further magnified under a complex capital structure where the Company may have several other obligations to meet in the pecking order first, such as secured debt, convertible hybrid instruments, etc. The Company may also have obligations to Government Departments. These factors result in Equity holders demanding a higher rate of return, for absorbing this risk. Thus, the Cost of Equity is higher than cost of Debt.

When new debt is issued at high finance costs, i.e. high rates of interest, the Company may face additional turmoil during uncertain or difficult financial situations as it increase the risk of insolvency. Where the Company is already highly leveraged (high debt to equity ratio) and new debt is issued at a high rate, the Company may face slower growth rates because of the obligation to service debt before pumping resources into high growth projects and endeavours. Further, the cost of debt also determines the cash flow to equity.  

However, the one of the biggest advantages of debt over equity is that interest cost is allowed as a deduction for the computation of tax. This in turn lowers the tax liability. Thus, the actual cost of debt is lower than stated cost by the amount of the tax saving benefit.  

The management of the Company is required to provide regular information for the investors / shareholders to monitor. Investors / Shareholders regularly seek comprehensive updates about the business, financial and performance information, guidace for the future, etc. This is especially true for newer investors that are still gaining comfort about the Company This is largely avoided when Debt instruments are issued.  

Raising equity finance is very demanding on the management of the Company. It is costly and time consuming. Unfortunately in many cases, it diverts management attention away from the core business and towards issues concerning valuations and how to magnify valuation at which equity should be issued. There is also extensive regulatory compliance required for issue of equity. Comparatively, the process of issue of debt instruments is less intensive.  

In terms of cost for new issue of equity, the issue itself requires participation and contribution from corporate lawyers, underwriters / investment bankers, registrars and accountants.Generally, the Company will have to hire consultants to manage the entire process. Overalll this process may take months at a time. Further, all these costs may be wasted if during those months there is major fluctuation in the market cycle or even in business performace and valuations are effected.  

Issuance of Debt will also entail some legal fees, consultancy fees, regiatration fees, etc. but the magnitude of such costs is much lower. Further, due to the fixed payments projected, there is no uncertainty involved. As long as business is stable, market conditions do not have a sizeable impact of issue of debt. Variations in valuations also do not influence these costs much.