It is seen that AMSC is a fast-growing company on US public markets in the energy sector. Its main customer is the Chinese energy major Sinovel, whose business accounts for a large segment of AMSC’s profits. This company has foregone its decision for debt financing of $50 million and is thinking in terms of going for a public issue of the amount.
Advantages of going in for equity issue
The decision to prefer a public issue rather than debt financing could stem from a variety of reasons which need to be seen as follows:
Stocks being highly overvalued
In most cases, companies go in for equity issues when they feel that their stocks are highly overvalued, and thus, through market operations, the value of a stock is corrected, since “even if the company’s stock is currently fairly valued, the market reaction to the announcement of a new equity offering is expected to cause the company’s stock price to fall below fair value.”
In most cases, the signals that investors get are that the company is overvalued, and the fall in stock prices that precedes the equity issue would make necessary corrections in the imbalances and unrealistic nature of stock prices.
In the case of AMSC, it is seen there have been increases in the value of equity as a proportion of assets, in that while it was 76% in 2006, it has risen to 79% during 2007. Thus it could be said that stock prices need to reflect their true value in as much as the true and fair view of accounting statements are concerned, and it would be in the best interests of AMSC to go in for an equity issue. “The company’s stock, which closed yesterday at $12.20, up 60 cents on the Nasdaq Stock Market, has risen 305 percent this year.”
It is seen that AMSC is in the energy sector and is engaged in high investment projects in wind and non-conventional energy sectors. These sectors are characterized by projects with high gestation periods and the long wait for projects to break even and render profits. Under such circumstances, seeking debt capital would be as expensive as injudicious since heavy investments, in $ trillions, cannot always be financed safely with debt capital. Under such circumstances, it would be in the fitness of things to opt for a safer option of public issues, which could earn a large capital base and also ensure that immediate returns need not be set forth to meet the cost of these investments. Moreover, dividends to equity shareholders are optional and at the discretion of the company, while interests are mandatory, and need to be paid, profits or no profits.
Volatile movements of AMSC stocks in stock markets
It is seen that the stock of AMSC is subject to substantial fluctuations and vicissitudes, often having nothing to do with the performance of the company. Under such circumstances, it is seen that an equity issue could broaden the capital base and, by diluting the capital, could ensure that the volatility could be effectively controlled.
Risks of compulsory dissolution of the company
Debt capital needs to be financed with periodical interest payments and final principal repayment upon maturity of the debt. In the event this is not met, there are risks of lawsuits for creditors’ claims and eventual winding up of the company in the event these claims are not settled. With regard to equity capital, such risks do not arise, and the issue relating to equity repayment would only arise finally after the formal dissolution of the company.
Disadvantages of going in for equity issue
Loss rendering company
It is seen that AMSC is a loss-incurring company. “Our net losses were $25.4M, $34.7M and $30.9M during the fiscal years 2007.2006 and 2005 respectively. Our accumulated deficit end of the fiscal year 2007 is $410.5Milion.”
Thus, it is seen that successive losses would have eroded reserves, and the company, having good cash reserves, does not have robust earnings and surplus that could support it in later years. In the eventuality of closure of AMSC operations, the return of capital to equity shareholders would come up. This would be a major issue that needs to be forecasted and addressed at present.
Non-dividend paying company
Further, the company is not in the habit of paying dividends, and this could be cause for complaints of the shareholders.” However, it could also be seen that if a firm uses project-specific weights, projects financed with debt will have lower costs of capital than projects financed with equity.”
Besides being a technically oriented company, it is also necessary that necessary administrative and commercial aspects of business also need to be prioritized, and therefore, in the event of a public issue, its present track record would come under the scanner. Dividends are the returns for the risks taken by shareholders, and to deny them these returns, in the normal course, do not augur well for the company. It will make better business sense if high R&D costs at the inception are written off over a long-term period of the company in order that its impact on yearly profits does not occur. Thus, each year, the amortized part of the expenses would figure in their account, allowing leverage for other activities and projects.
Dilution of control
Another disadvantage of equity could be in terms of dilution of control of the company in that new equity shareholders would be entitled to be represented at a general meeting, vote, and decide the course of executive decisions making on crucial issues. They would be in a position to control affairs of the company either directly or indirectly, including appointment, election, and retirement of directors and auditors of the company.
For present loss-making companies like AMSC, it is far more prudent to seek equity from the equity market rather than debts from the money markets. This is because, in the event of winding up proceedings, the risk from equity is lower than from debt capital.
Moreover, in the event contracts are terminated while in progress due to governmental interferences or technical snags, the negative impact of debts would be significantly higher than that of equity capital. The measure of securing risks under equality is much higher than debt, as is the cheaper availability and comparatively risk-free.
Moreover, in the context of the energy sector, the investments are massive, with long gestation periods during which interests payments would have to be paid without concomitant earnings in the case of debt capital. “The company reported backlog as of March 31, 2009, of approximately $558 million compared with $602 million as of December 31, 2008, and $199 million as of March 31, 2008. The year-over-year increase is due primarily to a $450 million, three-year contract for wind turbine core electrical systems the company received from Sinovel Wind Company in June 2008. The decline from December 31, 2008, in backlog is due primarily to shipments under the Sinovel contract.”
While the decision whether to go in for an equity issue or debt is much circumstantial and market-driven (interest rates, cost of capital, the quantum of funds needed, repayment schedule, etc.) in the case of AMSC, the choice would weigh heavily in favor of equity capital because it carries fewer risks and does not seek mandatory interest commitments, when compared with debt capital. Moreover, in AMSC’s case, debt capital would place a strain on its bottom line, especially when it has just emerged from the red and is beginning to post profits. The idea would be for AMSC to continue to post healthy profits over its useful years and finally, opt for a leveraged buyout (LBO) that “could allow a small group of investors, usually including current management, to acquire a firm in a transaction financed largely by debts.” This would set right the loss of control aspects and bring back the company in a stronger position boosting sales and profits.
The main aspects in balancing debt with equity would be to get the best benefits from both, in terms of both liquidity and risks, and also in terms of repayment of liability at future dates, and the optimum use for the project and working capital requirements.