Question

When a company needs capital, for instance to fund adding a new facility, they have two options of issuing common stock or utilizing retained earnings. There are many costs involved, I was going to say financial and otherwise but in the end they all come down to financial in the end. One of the largest considerations would be is does the company want to give up even more ownership of the company. By issuing new common stock they are selling part ownership of their company where as using retained earnings may reduce the financial stability, the funds to cover outstanding debts and such, it maintains the same percentage of ownership as prior to the capital investment. Then the current owners will not have to share in any additional profits resulting from that investment; they will be able to reinvest the profit to cover the retained earnings that were utilized and then save, spend on other projects or pay out to owners however if they had sold stock the profit made from such project would be shared with the additional new owners as well.  

How else would this decision impact a company?    Can you provide actual financial examples?

Answer 1

The decision to raise capital is on of the most cricial ones for a company. In the question it talks about two options. The first one is issuing common stock and second one is utilising the retained earnings.

Case 1: Issuing of Common Stock:

If a firm goes by this option of raising captial then the most important thing that it is giving up is it's control power. Since equity shares carry voting rights the firm will grant the rights to the common stock holders in the profit of the company.The effect of this will be such that the cost of equity or the dividend payout of the firm will increase and the profits of the founders will decrease. Increased cost of equity will lower the debt to equity ratio of the firm and this will have a negative impact on the overall value of the firm as well.

The next infulence that the issuing of common stock will have is that the shareholders will be actively watching the movements of the stocks of the firm and they will have the power to affect the management decisions of the firm as well.

No matter if the equity shareholders are paid the dividends at the last of all the stakeholders in a firm they have the power to influence the managerial decision making and decreasing the profit on part of the founders of the firm.

One such example of the same is the recent investment of many multinatinal firms in the Indian Firm Reliance. Reliance company recently sold its stake to many multinationals giant thereby giving up its control rights to some extent.

Case 2: Utilising the Retained Earnings:

If a firm utilises it's RE then upto a certain extent it will se a decline in the RE. But this decrement will be somehow have a positive impact. Fisrtly the firm will not have to give up on it's controlling rights as in the case of raising funds from equity. Secondly if there is a generation of profits and the investment from the RE results positive cash inflows then the firm can plough back the amount that it invested from the RE and also increase it's RE.

Once the level of profits increase then even if the firm doesn't earn any profits or earn less profits it can easily payout dividends to the existing shareholders.

The cost of retained earnings is soley borne by the founders of the company and hence if the company wants to extend it's operations then utilisation of it's RE is a better option over issuing of common stock.