Debt and equity as strategic options for business capital raising

Finance

Questions on Capital Raising

Advice on Raising Capital

When businesses wish to expand they are likely to require further capital to support that growth. If the firm does not have sufficient internal capital, they will need to turn to external sources to raise funds, with two main options; debt or equity.

Debt is capital that is raised which will need to be repaid, usually in the form of a loan or the issuance of a corporate bond. The company will then be required to pay interest in the debt, it is usual for the interest payments to be due at regular intervals, such as monthly, quarterly, twice a year or annually, depending on the type of debt instrument used. In some cases, for example loans made to property developers, the interest may be rolled up and payable when the loan is repaid (Howells & Bain, 2007). The lender will make the funds available to the borrower with the aim of making a profit; the profit will come from the interest and fees charged for making the loan. The fees and interest rate will be determined by a number of factors, including the prevailing interest rates and the degree of risk associated with the loan. The potential risk of default is assessed, the higher the risk premium needed by the lender and the more costly the loan, the lower the risk the lower the interest rate (Howells & Bain, 2007).

There are both advantages and disadvantages associated with debt. Debt does not confer any ownership rights on the lenders, and may be popular with the shareholders as it does not dilute shareholding. It can be cost-effective to raise debt, especially compared to raising equity, and when interest rates are low, it maybe argued that debt may be cost-effective, especially if the borrower is able to raise funds on a fixed interest rate loan (Howells & Bain, 2007). However, there are also some disadvantages; debt will require repayment of both the principal and interest payments, which may increase the pressure on the organization and is not required and an equity issue. Where interest payments are made, interest payments are tax deductible. Caveats may be associated with the raising of debt, for example lenders may require security, or require borrowers to make commitments regarding the way in which they will operate, use or dispose of assets or other controls on the organization's activities (Howells & Bain, 2007).

The raising of equity allows the firm to gain an inflow of capital as a result of issuing shares and granting ownership to those who provide the equity. Equity is not a loan, it is an investment, and confers ownership rights on the investors. Where shares issued, each share will contain equal rights in terms of voting, and rights to dividends. Investors will usually make equity investments with the aim of creating profit; this can be achieved through capital growth of the share price, as well as the receipt of dividends. A specific advantage associated with the use of equity is the low costs; dividends are not compulsory on equity investments, and the investment does not need to be repaid, which can be a significant advantage compared to debt. However, raising equity finance can be costly, especially if it is through a share issue. Furthermore, the issuance of shares dilutes ownership, and therefore the rights and potential returns of the existing owners.

One consideration may be the costs associated with both debt and equity, but according to equity arbitrary, it maybe argued that the risk premium associated with the company should be based on the company's activities, and therefore the cost difference between debt and equity should be minimal (Miller, 1988).

Relationship between Risk and Return in Bonds and Stocks

The historical relationship between risk and return on, stocks vs. corporate bonds reflects the degree of security that is associated with the bonds, which is perceived as lowering the risk (Friedman, 1982). Corporate bonds are a form of loan, and while there is some risk; if the company folds there is a risk that the bonds will not be repaid; bondholders rank below other forms of creditors who have physical security within the organization. There are also risks that some companies may default on their bonds, and will not pay interest be able to repay them. However, as bondholders are higher in the level of priorities compared to stockholders, the level of risk associated with holding a corporate bond is usually deemed to be less than the equivalent stock in the same organization. This means that in terms of the risk premium, and the amount required tends to be less for a bond compared to the expected return on an equivalent equity investment (Friedman, 1982).

Equity investments are more risky than bonds, if a company folds, stockholders will be the last in the line of creditors, and as companies usually followed when they cannot pay all their creditors, stockholders will usually receive nothing on a company failure. This means that the risk premium is likely to be higher, and therefore although the risk is higher, the potential return is also higher.