Question

Outdoor Living Ltd., an owner-managed company, has developed a new type of heating using solar power, and has financed the development stages from its own resources. Market research indicates the possibility of a large volume of demand and a significant amount of additional capital will be needed to finance production. Advise Outdoor Living Ltd. on: (a) the advantages and disadvantages of loan and equity capital (b) the various types of capital likely to be available and the sources from which they might be obtained (c) the method(s) of finance likely to be most satisfactory to both Outdoor Living Ltd. and the provider of funds.

Answer 1

Answer :

Part a)

Advantages of Equity Capital

It has several advantages:

• The firm has no obligation to redeem the equity shares since these have no maturity date.
• The equity capital act as a cushion for the lenders, as with more and more equity base, the company can easily raise additional funds on favorable terms. Thus, it increases the creditworthiness of the company.
• The firm is not bound to pay dividends, in case there is a cash deficit. The firm can skip the equity dividends without any legal consequences.

Disadvantages of Equity Capital

There are several disadvantages of raising the finances through the issue of equity shares which are listed below:

• With the more issue of equity shares, the ownership gets diluted along with the control over the management of the company.
• The cost of equity capital is high since the equity shareholders expect a higher rate of return as compared to other investors.
• The cost of issuing equity shares is usually costlier than the issue of other types of securities. Such as underwriting commission, brokerage cost, etc. are high for the equity shares.
• The cost of equity is relatively more, since the dividends are paid out of profit after tax, but the interest payments are tax-deductible.

Advantages vs. Disadvantages of Debt Financing

Advantages:

• Retain control. When you agree to debt financing from a lending institution, the lender has no say in how you manage your company. You make all the decisions. The business relationship ends once you have repaid the loan in full.
• Tax advantage. The amount you pay in interest is tax deductible, effectively reducing your net obligation.
• Easier planning. You know well in advance exactly how much principal and interest you will pay back each month. This makes it easier to budget and make financial plans.

Disadvantages : Debt financing has its limitations and drawbacks.

• Qualification requirements. You need a good enough credit rating to receive financing.
• Discipline. You’ll need to have the financial discipline to make repayments on time. Exercise restraint and use good financial judgment when you use debt. A business that is overly dependent on debt could be seen as ‘high risk’ by potential investors, and that could limit access to equity financing at some point.
• Collateral. By agreeing to provide collateral to the lender, you could put some business assets at potential risk. You might also be asked to personally guarantee the loan, potentially putting your own assets at risk.

Part 2 :

Sources of funds

A company might raise new funds from the following sources:

1. The capital markets:i) new share issues, for example, by companies acquiring a stock market listing for the first time ii) rights issues
2. Loan stock
3. Retained earnings
4. Bank borrowing
5. Government sources
6. Business expansion scheme funds
7. Venture capital
8. Franchising.

Financing is needed to start a business and ramp it up to profitability. There are several sources to consider when looking for start-up financing. But first you need to consider how much money you need and when you will need it.

The financial needs of a business will vary according to the type and size of the business. For example, processing businesses are usually capital intensive, requiring large amounts of capital. Retail businesses usually require less capital. Debt and equity are the two major sources of financing. Government grants to finance certain aspects of a business may be an option. Also, incentives may be available to locate in certain communities and/or encourage activities in particular industries.

Part 3.

Equity Financing

Equity financing means exchanging a portion of the ownership of the business for a financial investment in the business. The ownership stake resulting from an equity investment allows the investor to share in the company’s profits. Equity involves a permanent investment in a company and is not repaid by the company at a later date.

The investment should be properly defined in a formally created business entity. An equity stake in a company can be in the form of membership units, as in the case of a limited liability company or in the form of common or preferred stock as in a corporation.
Companies may establish different classes of stock to control voting rights among shareholders. Simi­larly, companies may use different types of preferred stock. For example, common stockholders can vote while preferred stockholders generally cannot. But common stockholders are last in line for the company’s assets in case of default or bankruptcy. Preferred stockholders receive a predetermined dividend before common stockholders receive a dividend.

Personal Savings
The first place to look for money is your own savings or equity. Personal resources can include profit-sharing or early retirement funds, real estate equity loans, or cash value insurance policies.

Venture Capital
Venture capital refers to financing that comes from companies or individuals in the business of investing in young, privately held businesses. They provide capital to young businesses in exchange for an ownership share of the business. Venture capital firms usually don’t want to participate in the initial financing of a business unless the company has management with a proven track record. Generally, they prefer to invest in companies that have received significant equity investments from the founders and are already profitable.

They also prefer businesses that have a competitive advantage or a strong value proposition in the form of a patent, a proven demand for the product, or a very special (and protectable) idea. Venture capital investors often take a hands-on approach to their investments, requiring representation on the board of directors and sometimes the hiring of managers. Venture capital investors can provide valuable guid­ance and business advice. However, they are looking for substantial returns on their investments and their objectives may be at cross purposes with those of the founders. They are often focused on short-term gain. Venture capital firms are usually focused on creating an investment portfolio of businesses with high-growth potential resulting in high rates of returns. These businesses are often high-risk investments. They may look for annual returns of 25 to 30 percent on their overall investment portfolio.

Because these are usually high-risk business investments, they want investments with expected returns of 50 percent or more. Assuming that some business investments will return 50 percent or more while others will fail, it is hoped that the overall portfolio will return 25 to 30 percent.

More specifically, many venture capitalists subscribe to the 2-6-2 rule of thumb. This means that typically two investments will yield high returns, six will yield moderate returns (or just return their original investment), and two will fail.

Government Grants
Federal and state governments often have financial assistance in the form of grants and/or tax credits for start-up or expanding businesses.

Equity Offerings
In this situation, the business sells stock directly to the public. Depending on the circumstances, equity offerings can raise substantial amounts of funds. The structure of the offering can take many forms and requires careful oversight by the company’s legal representative.

Initial Public Offerings
Initial Public Offerings (IPOs) are used when companies have profitable operations, management stability, and strong demand for their products or services. This generally doesn’t happen until compa­nies have been in business for several years. To get to this point, they usually will raise funds privately one or more times.

Debt Financing :

Debt financing involves borrowing funds from creditors with the stipulation of repaying the borrowed funds plus interest at a specified future time. For the creditors (those lending the funds to the business), the reward for providing the debt financing is the interest on the amount lent to the borrower.

Debt financing may be secured or unsecured. Secured debt has collateral (a valuable asset which the lender can attach to satisfy the loan in case of default by the borrower). Conversely, unsecured debt does not have collateral and places the lender in a less secure position relative to repayment in case of default.

Debt financing (loans) may be short term or long term in their repayment schedules. Generally, short-term debt is used to finance current activities such as operations while long-term debt is used to finance assets such as buildings and equipment.

Banks and Other Commercial Lenders
Banks and other commercial lenders are popular sources of business financing. Most lenders require a solid business plan, positive track record, and plenty of collateral. These are usually hard to come by for a start- up business. Once the business is underway and profit and loss statements, cash flows budgets, and net worth statements are provided, the company may be able to borrow additional funds.

Government Programs
Federal, state, and local governments have programs designed to assist the financing of new ventures and small businesses. The assistance is often in the form of a government guarantee of the repayment of a loan from a conventional lender. The guarantee provides the lender repayment assurance for a loan to a business that may have limited assets available for collateral. The best known sources are the Small Business Administration and the USDA Rural Development programs.

Bonds
Bonds may be used to raise financing for a specific activity. They are a special type of debt financing because the debt instrument is issued by the company. Bonds are different from other debt financing instruments because the company specifies the inter­est rate and when the company will pay back the principal (maturity date). Also, the company does not have to make any payments on the principal (and may not make any interest payments) until the specified maturity date. The price paid for the bond at the time it is issued is called its face value.

Lease

A lease is a method of obtaining the use of assets for the business without using debt or equity financ­ing. It is a legal agreement between two parties that specifies the terms and conditions for the rental use of a tangible resource such as a building and equipment. Lease payments are often due annually. The agreement is usually between the company and a leasing or financing organization and not directly between the company and the organization providing the assets. When the lease ends, the asset is returned to the owner, the lease is renewed, or the asset is purchased.