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We review and study the decisions that a company makes in terms of both debt and equity and how these choices change over a business's life cycle. In particular, we look at how the decisions change as a company goes from being a small, personal business to a large multi-national – and eventually a publicly traded corporation. We weigh the underlying trade-offs between using debt and equity by measuring the advantages of borrowing against the costs.
Most investors think of equity in terms of common shares, though the equity claims on a business generally takes many forms, based on if the firm is privately owned or publicly traded and partly on the business's growth and risk characteristics. Private companies have fewer opportunities available than do publicly traded companies, since they cannot issue stock to raise equity.
Consequently, companies must rely either on the owner or a private funding source, frequently a venture capitalist, to secure the equity required to keep the business solvent and growing. Publicly traded companies generally have greater access to equity and debt and lower fees than private businesses.
The majority of companies, including many of today’s most successful companies, such as Google and Facebook, began as small businesses with one or a handful of individuals providing the initial seed money and investing the earning of the company back into business. Such funding, made possible by the owners of the company, is the owner's equity and provides the foundation for the growth and eventual success of the business.
As small companies succeed and grow, they typically run into funding constraints, where the funds on hand are being depleted faster than they can gain access to new funds. This is commonly referred to as cash burn. At this point, a venture capital or private equity investor may provide equity financing to small and often risky businesses in return for a share of the ownership of the firm.
The traditional method of raising capital for a publicly traded firm is to issue common stock at a price the market will pay. For a newly listed company, the offering price is approximated by the investment banker.
Common stock is a straightforward security, and it is simple to understand and value. In fact, it can be contended that common stock makes feasible other security choices for the publicly traded company, because a firm without equity cannot issue debt or hybrid securities.
A stock warrant is an option to purchase a specified number of shares of common stock at a stated price. Warrants are often employed as “sweeteners” to a public issue of bonds or privately held debt.
Issuing warrants is a great way for a high-growth firm to raise money, especially when current cash flows are low or negative.
Debt is a substitute for using equity, which is a residual claim. Borrowing money creates a fixed obligation to all future cash flow payments and provides the lender a senior claim ahead of equity holders if the firm is in financial trouble.
Historically, banks have been the primary source of borrowed money for private companies and many publicly traded companies, with the interest rates on the financial debt based on the perceived risk of the borrower. Bank debt provides the debtor with several benefits. First, it can be used for borrowing relatively small amounts of money; in comparison, bond issues benefit from economies of scale, with bigger bond issues producing lower costs. Second, if the company is unpopular or not recognized and followed by analysts, bank debt is a convenient mechanism to share information to the lender that will help in both pricing and evaluating the actual loan; in other words, a borrower can provide internal information about new investments and the company to the financing bank.
For larger, publicly traded companies, an alternative to bank financing is to issue corporate bonds. In many cases, the use of corporate bond has many advantages. One is that bonds typically enjoy more favorable lending terms compared to the comparable bank loan, while risk is shared with a greater number of institutional investors. Two, corporate bond issuers are given the option of adding special features not available with bank debt. For example, bonds can be convertible into common stock or even be tied to commodity prices.
A better way to financing asset purchases that otherwise would accomplish the same thing as debt is to lease the asset. With a lease, the company promises to make set payments to the proprietor of the asset for the privilege to use the asset.
A lease contract is typically classified as either an operating or a capital lease. For operating leases, the structure of the lease terms is shorter than the life of the asset, and the present value of lease payments is commonly lower than the actual price of the asset. At the end of the lease term, the asset goes back to the lessor, who typically will offer to sell it to the lessee or lease it to someone else.
A capital lease normally lasts for the life of the asset, with the present value of lease payments covering the price of the asset. A capital lease generally cannot be terminated, and the lease can be extended at the end of its life at a lower rate or the asset purchased by the lessee at a substantially lower price.
A convertible bond obligates the issuing firm either to redeem the bond at par value upon maturity or to allow the bondholder to convert the bond into a pre-specified number of shares of common stock. If the conversion value of the bond at maturity exceeds its face value, then the bondholders will convert it into stock.
Preferred stock is another security which shares some features with debt and some with equity. Like debt, preferred stock has a fixed dollar dividend; if the company cannot pay a dividend, the dividend accumulates and paid at a time when the company has retained earning. Similar to debt, preferred stockholders have no voting rights restricting them of any control of the firm.
Many companies have identified the benefit of tying options together with traditional corporate bonds to produce bonds that much more closely match the firm's specific requirements. Commodity companies issue bonds linking the principal and even interest payments to the price of the commodity. Interest payments fluctuate with the changes in commodity prices, higher commodity prices increase interest payments and vice versa. The advantage for the firm is a custom-made cash flow on the bonds to the cash flows of the firm which customarily reduces the chance of default.
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Consulting Services We Provide
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- Net Present Value and IRR
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This email is intended for general information purposes only and should not be construed as legal advice or legal opinions on any specific facts or circumstances.