Advantages for AMSC to forgo their debt financing and take on equity financing
Permanent capital
Equity financing is a permanent source of capital because ordinary shares are not redeemable; therefore the funds raised from this source are available for use as long as the company is in existence. It also follows that the company has no liability for cash outflow associated with repayment of ordinary capital because ordinary shares are not redeemable. Debt funds have to be repaid, and do not therefore offer such permanent capital. By adopting equity financing as opposed to debt financing, American Superconductor is able to make use of this permanent capital (Gotthilf, 1997).
Dividend payment discretion
Payment of dividend is normally at the discretion of management. When a company is facing financial difficulties, it can reduce the amount of ordinary dividends or even suspend them altogether, without much problem from the equity holders. Ordinary dividends can also be paid in other forms, leaving the cash to be used for other more pressing needs. A company which uses debt funds does not have such pleasure because it has to make regular capital and interest repayments on the loan. By adopting equity financing as opposed to debt financing, American Superconductor is able avoid compulsory cash outflows associated with loan and interest repayments when it has cash flow problems.
Avoiding financial distress
When a company uses debt financing, it is constantly exposed to financial distress which may come as a result of defaulting on loan repayments. Such a company is constantly harassed by the debt holders. Such financial distress may lead to the company being taken over by the debt holders. By adopting equity financing as opposed to debt financing, American Superconductor avoided such financial distress.
Flexibility
Debt contracts usually have some restrictive covenants which prevent the company from raising additional debt funds, or disposing of its fixed assets, or paying dividends to equity holders. A company which uses debt funds is less flexible because it cannot do what is prohibited in the restrictive covenants. By adopting equity financing as opposed to debt financing, American Superconductor avoided such restrictive covenants, thus remaining flexible.
No bankruptcy costs
A company which uses debt capital has high chances of being declared bankrupt when it is unable to repay the borrowed funds. When a company goes bankrupt, it incurs direct costs, such as legal and other deadweight costs; and indirect costs, such as lost sales. By adopting equity financing as opposed to debt financing, American Superconductor avoided such bankruptcy costs (Damodaran, n. d).
No agency costs
There are usually agency costs that are incurred by debt holders to ensure that management act in the best interests of the debt holders. These expenses are usually met by the company. By adopting equity financing as opposed to debt financing, American Superconductor avoided such agency costs.
Disadvantages for AMSC to forgo their debt financing and take on equity financing
Loss of tax benefits
When calculating profit before tax for tax purposes, companies are normally allowed to deduct interest on debt funds as an expense, thus reducing the amount of income to be taxed, and eventually reducing the amount of tax to be paid by the company. Dividends paid to equity holders cannot be deducted from income in arriving at taxable income, which means that a company which only uses equity funds would pay more tax than a similar company which has the same gross income but also pays interest on debt. By adopting equity financing as opposed to debt financing, American Superconductor cannot take advantage of this provision, and therefore has to pay more tax.
Cost
Equity funds are generally more costly than debt fund because of the ordinary dividends not being tax deductible, and also because floatation costs on ordinary shares are normally higher than those on debt. By adopting equity financing as opposed to debt financing, American Superconductor has had to pay the high cost.
Risk
Investors normally require a relatively higher rate of return on equity funds because they view ordinary shares as a riskier investment due to the uncertainty of dividends and capital gains. This makes equity fund the most expensive source of funds. By adopting equity financing as opposed to debt financing, American Superconductor has had to pay this high price.
Earnings dilution
When additional ordinary shares are issued, earnings do not increase immediately, meaning that the same income has to be divided by the new larger number of ordinary shares. The shareholders who were there before the new issue would therefore experience a decrease in their earnings per share, thus a dilution in their earnings per share. For a company which use debt funds instead of issuing additional ordinary shares each time they need funds, earnings per share are not diluted since the number of shareholders remains the same. By adopting equity financing as opposed to debt financing, American Superconductor has exposed its ordinary share holders to this dilution in earnings per share (Harvey, 2002).
Ownership dilution
When additional ordinary shares are issued, ownership and control of the existing shareholders is diluted, since the company is now owned and controlled by more share holders. Shareholders who do not have funds to invest in the additional shares are bound to lose their pre-emptive right to retain their proportionate ownership. In closely held companies, dilution of ownership assumes great significance. In companies which use debt funds instead of issuing additional ordinary shares each time they need funds, ownership is not diluted since the number of shareholders remains the same. By adopting equity financing as opposed to debt financing, American Superconductor has exposed its ordinary share holders to this dilution in ownership.
Lack of management discipline
Debt funds usually instill some amount of discipline in management, because they have to work hard to repay the debt otherwise there would be serious consequences. For a company which uses only equity funds, management do not fear any consequences and are therefore less disciplined. By adopting equity financing as opposed to debt financing, American Superconductor has exempted its management from this kind of discipline.
Opinion on American Superconductor’s decision
In my opinion, it was not right for American Superconductor to adopt 100 % equity financing, since the disadvantages of using equity capital have more serious effects than the advantages. I would suggest that they instead find an optimal mix of debt and equity funds. Such a mix should minimize the company’s weighted average cost of capital, and at the same time maximize the value of the company.
Reference List
Damodaran, A. (n. d). The Debt-Equity Trade Off: Stern School of Business, 2007. Web.
Gotthilf, D. (1997). Long-term borrowing techniques: Treasurer’s and Controller’s Desk Book. New York: American Management Association
Harvey, C. (2002). How do CFOs make capital structure and budgeting decisions. Web.