Question

Assume that our class owns corporation A and further that we control all issued stock. We need capital for expansion; however, we are unable to make additional contributions. Do you recommend that we issue stock to new investors or obtain debt financing through the sale of bonds? Explain your answer. What are the benefits and drawbacks of each approach?

Answer 1

Advantages of issuing stock to new investors:

You have less risk with equity financing because you don't have any fixed monthly loan payments to make. This can be particularly helpful with startup businesses that may not have positive cash flows during the early months.If you have credit problems, equity financing may be the only choice for funds to finance growth. Even if debt financing is offered, the interest rate may be too high and the payments too steep to be acceptable.Equity financing does not take funds out of the business. Debt loan repayments take funds out of the company's cash flow, reducing the money needed to finance growth. Equity investors do not expect to receive an immediate return on their investment. They have a long-term view and also face the possibility of losing their money if the business fails.

Disadvantages of issuing stock to new investors for expansion:

Equity investors expect to receive a return on their money. The business owner must be willing to share some of the company's profit with his equity partners. The amount of money paid to the partners could be higher than the interest rates on debt financing.The owner has to give up some control of his company when he takes on additional investors. Equity partners want to have a voice in making the decisions of the business, especially the big decisions.All the partners will not always agree when making decisions. These conflicts can erupt from different visions for the company and disagreements on management styles. An owner must be willing to deal with these differences of opinions.

Advantages of obtaining debt financing through sale of bonds:

When your company sells bonds, you agree to pay investors interest in exchange for using their money. That interest is tax-deductible as an expense for your company. Bondholders don't own a piece of your business and they don't participate in your decision-making. Another advantage of bonds is that you can issue them whenever you need money. This is in sharp contrast to stocks, which companies typically issue only once, because a second offering of stock tends to dilute the share price due to extra supply. Bonds also offer the advantage of allowing you to borrow money only for the time you will need it. For example, you can issue two-year, five-year and 10-year bonds, instead of 30-year bonds. Keeping the bond term as short as possible saves you money, because you can limit the amount of time you pay interest.

Disdavnatages of obtaining debt financing through sale of bonds:

You must pay interest payments on time to bondholders. This differs from dividends, which you only have to pay when you declare one. You pay interest according to a strict timetable. This can create problems with your cash flow. In other words, you may have times when you wish you could use your cash for expansion or to buy assets, but you have to pay the interest on your bonds instead. Another disadvantage of bonds is that they increase the amount of debt you show on your books. Investors often look at debt as a factor that makes a company attractive or unattractive. You will eat up a portion of your future profits paying your bond interests. Also, you will need to maintain a good credit rating if you want to issue bonds in the future. Otherwise, you could have to offer high interest rates to attract investors.