Equity and Debt Capital Structure

Equity and Debt

Capital structure decisions are generally considered to be major decisions by managers, because they impact the firm in a number of ways. Public firms seldom issue further equity because it has a higher cost than do debt issues and because it results in a dilution of ownership, but there may be strategic considerations that compel management to issue equity after the IPO.

One of the major considerations that must be considered when a firm tries to decide how to raise capital is the issue of cost. In general, equity has a higher cost that does debt. Debt issues, by virtue of having a set, guaranteed payment, are viewed to have lower levels of risk. Equity issues have no guaranteed payments -- indeed returns of any sort are not guaranteed -- and this makes them riskier investments. Because risk is typically correlated with return, the return to investors must be higher to compensate for the increased risk. Therefore, the cost of equity is typically higher than the cost of debt. The firm's cost of capital is often a consideration in capital budgeting decisions. A firm with a high cost of capital can only use that money to engage in relatively risky projects that will have higher expected returns. Firms with a lower cost of capital have more flexibility to take on safer projects. The result is that the more debt a firm carries, the safer the projects it can take on.

The firm's total risk does not change despite its capital structure. This means that while debt is lower risk for investors, it is higher risk for the company and its shareholders. A firm with a high debt level is said to be highly leveraged. Remember that debt represents an obligation to pay the debt holder. The higher the amount of the firm's earning must be paid out to the debt holders, the greater the risk to the firm. Therefore, a firm with a high degree of leverage is said to have a high degree of risk. If its cash flows become compromised, it can experience reduced liquidity or even solvency. Management must therefore consider its current and future debt levels when deciding on the best means to raise money (Hillstrom, 2010).

Another consideration is raising capital in the future. Firms with high debt levels may find it difficult to raise money in the future, because of the risk that they have. Equity investors would be subordinated to the high debt, and other debt investors would also see the high risk inherent in a highly-leveraged company as cause for concern (Hillstrom, 2010).

The decision of American Micro Semiconductor in 2003 to undertake an equity issue instead of a debt issue must be examined in the context of the company's financial situation and competitive situation at the time. The company's cash flows were expected to grow with stability as the Northeast blackout highlighted the need for utilities to modernize, which would give AMSC more business. The company also had a growing presence in the perpetually-expanding Chinese market (Esposito, 2003).

One of the factors that guided this decision was the strength of the company's stock at the time. AMSC had announced a letter of intent for secured debt financing in July of 2003 (AMSC 2003 Annual Report) when the stock was trading in the range of $8 per share. The blackout gave the firm's stock considerable momentum, and it finished the month of August up over 50% at $12.19 per share (MSN Moneycentral, 2010). Equity issues normally result in dilution of the stock price, since the issue must be offered at a discount to the current price in order to attract investors. With the stock price spike, however, such a discount would still be above the July price, or indeed any price the company's stock had seen in the previous 18 months. Thus, the impacts of the dilution would be minimal to the existing shareholders.

The decision may also have been made on the basis of capital structure. At the time, AMSC did not have any long-term debt. The July financing would have been the only long-term debt for the company. The firm had very strong liquidity ratios. Thus, the decision to issue equity also relates to management's aversion to debt. Debt aversion is one reason for choosing equity despite its higher cost. Firms sometimes prefer to match their financing terms with their revenue terms. A company focused on long-term growth or growth of indeterminate length may prefer to utilize equity financing specifically because of the flexibility it gives management. At AMSC, there was no reason given the firm's size and finances to have debt aversion, yet such aversion may simply have become an ingrained part of the managerial culture.

The other major financial consideration is the firm's current cash flow situation. While AMSC had a strong balance sheet at the time, it was losing money. The loss in fiscal 2003 was $4.21 per share, and had been rapidly increasing over the past few years. Although AMSC was an established business, one of its main lines of business, contracts, had dried up. Contract revenues declined from $3.1 billion in 2001 to $715 million in 2003. Contracts represent steady income flows that can easily be applied to debt. Without any certainty from this particular income stream, debt financing may have appear unattractive to management as it worked to grow different businesses, perhaps with less certain cash flows.