Question

Critically evaluate alternative sources of debt and equity finance for a company. Within your evaluation you are also required to propose criteria the company might use when considering which financing method(s) to use.

(700 words)

Answer 1

Debt financing and equity financing are important component of overall capital structure of a company. Company needs to find an optimal mix of both the type of financing in order to maximize the overall rate of return so that it can beat the cost of capital associated with both the form of financing and it will help in maximization of shareholders wealth and it will also help in achieving the long-term objective of the company.

Both sources of equity and debt financing needed to be properly evaluated in order to select one so that that could maximize the overall rate of return on investment for the company and it will also Yield into lower cost of capital for the company.

Various sources of debt financing are as follows-

A. Issuance of debenture is one of the most popular form of debt financing which includes issuance of debenture in the market and there would be whole lot of subscribers out there who will subscribe the debt of the company and earn interest payment on those debentures as well as these debentures are tax deductible so companies also going to benefit from it

B. Bank loans are another form of debt financing which are used to obtain higher chunk of capital and which are adding to the overall solvency risk of the company as this bank will always look for higher rate of credit worthiness and then it will provide the loan to the company.

C.that could also be obtained through flotation of various instrument in the money market such as certificate of deposits and other short term financing tools which will help in generation of debt through issuance of securities from money market.

Various sources of equity financing are as follows-

A. The most common source of equity financing is through issuance of new shares into the primary market segment of the capital market, where the company is issuing its equity stake and it is subscribed by the public at a certain price and this kind of equity ownership leads to dilution of the overall control on part of the company and the dividend payments are not tax deductible for the company as well, so the overall cost of equity is always higher than the cost of debt because there is no tax advantage associated with equity financing.

Preferred stocks are also issued by the company which have a combination of both debt as well as equity. The dividend payments are always to be paid to this kind of shareholders and this type of shareholders have a priority of claim on the Assets of the company before the equity shareholders and these can also add to the overall fixed payment obligation of the company and they are risky for the solvency claims.

Retained earning is another major part of equity financing which is generally associated with equity capital because retained earning are part of equity and there is no cost of issuance of retained earning because it is used as reserves and it is the cheapest cost of finance for a company.

A company should always try to find an optimal mix between various sources of financing because a company should always choose such mix of financing which will help in maximizing its overall rate of return, and which will also help in minimising the overall cost of capital so that the difference between the return on capital and the cost of capital helps in growth rate of the company.

Company who have a higher growth rate should always prefer a higher level of debt financing into its overall capital because of the interest payment tax advantage associated with it so that the company's cost of overall capital would be lesser and it can easily beat with the the return on the investment.

Trade off theory must be followed in order to obtain optimum mix because the benefits which are being yielded from interest rate tax shield should be traded off between the cost of Financial debt distress in case of debt financing.

So, a company always must focus on choosing and optimum mix of capital in order to to effectively maximize its rate of return