Equity and debt in corporate finance

Equity and Debt

AMSC has chosen equity financing rather than debt financing for general corporate purposes and to scale up manufacturing at Devens. The paper describes the advantages and disadvantages of each type of financing and performs an analysis on which option is the best for this company.

Debt Financing Advantages

There are many advantages of debt financing (What are the advantages and disadvantages of debt financing?, 2007) Most importantly, it allows a company to retain ownership and control so that it is able to make key strategic decisions and keep and reinvest more company profits. Debt financing also offers a great degree of financial freedom because debt obligations are limited to the loan repayment period, after which the lender has no further claim on the business. Debt that is paid on time can enhance a business's credit rating and make it easier to obtain various types of financing in the future. Debt financing is also easy to administer, as it generally lacks the complex reporting requirements that may accompany equity financing. Finally, debt financing tends to be less expensive over the long-term, though more expensive over the short-term, than equity financing.

Debt Financing Disadvantages

However, there are also many disadvantages of debt financing (What are the advantages and disadvantages of debt financing?, 2007). Debt financing requires a business to make regular monthly payments of principal and interest regardless of a company's profit or loss situation. This may be difficult for companies experiencing shortages in cash flow. Most lenders institute severe penalties for late or missed payments, which may include charging late fees, taking possession of collateral, or calling the loan due early. Failure to make payments on a loan, even temporarily, can adversely affect a business's credit rating and its ability to obtain future financing. Another disadvantage associated with debt financing is that its availability is often limited to established businesses because lenders primarily require security for their funds.

Equity Financing Advantages

Like debt financing, equity financing also has advantages (Equity finance). First, funds are committed to the business and its intended projects. Investors can only realize their investment if the company does well. Equity financing does not involve any obligation for the repayment of the debt.

Equity Financing Disadvantages

But, equity financing has pitfalls as well (Equity finance). The major disadvantage with equity financing is that the company is giving away partial ownership of the business in exchange for money. This can result of the loss of power to make certain management decisions. Raising equity finance is demanding, costly and time consuming and comes with extensive reporting and legal and regulatory compliance requirements.

The Best Choice for AMSC

For a number of reasons, AMSC has made a good decision to opt for equity financing rather than debt financing. Although things are looking up financially, the company still had a net loss of $8.4 million during its most recent quarter before the decision to take on equity financing (American Superconductor opts for secondary offering, 2003). Therefore, with cash reserves of only $12.1 million, there's some concern that the company could not make regular monthly debt payments on an ongoing basis. In particular, a forecast for a reduction in the cost of funding operations from $48 million to $13-$15 million is pretty drastic for a growth company and AMSC may end up with more operational costs than it is currently anticipating. Even if it could meet the regular debt payments, AMSC can use the money that would have gone towards those debt payments to further invest in its business which appears to have exciting growth potential.