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Business companies have many ways of raising funds that range from trading shares, debt financing and equity financing. However, the decision to use one form of raising funds, as opposed to the other, depends on the financial position of a company and the decision its management makes regarding the issue. Some of the fundraising ways have advantages than others. In the year 2003, American superconductor decided to raise funds through equity, as opposed to debt financing (American Superconductor Corporation, 2003). This happened from the intense discussions that the management had engaged in, and came up with that decision. This paper looks at the advantages and disadvantages of AMSC opting for equity financing and the ways of determining the cost of equity, of a company. It also looks at whether a tax deduction, from the use of debt financing exists.
The management of the American Superconductor Corporation believes that using equity financing as a way to raise funds serves in the best interest of its stakeholders. Equity financing involves selling partial interest in a company to investors. If AMSC uses equity, financing it does not have to repay in the traditional way. As long as the company makes profits, AMSC will repay its lenders without problem. The second advantages that equity financing provides AMSC involve the fact that it does not require any collateral. Therefore, can opt for equity financing without having to worry of how much collateral it may require to get the funds. Thirdly, the dividends that come from equity financing do not attract any tax deductions. This proves advantageous because the company will not spent any money on taxes with regard to equity financing. Lastly, investors offer advice to companies in equity financing because their interest lies in growth opportunities. Thus, AMSC will benefit from the advice of investors that will help the company to grow businesswise (Seidman, 2005).
However, equity financing has its own disadvantages. The AMSC Company must give up a certain amount of control of the company. If the investors oppose the day-to-day operations of the company, this will prove problematic. They may want to implement their own strategies because they must offer advice to the company. Another disadvantage that AMSC will incur involves the fact that certain equity sales, for instance, public offerings have complex procedures and may prove expensive for the company. They require complex filings and a lot of paperwork, to comply with certain regulations. This can also reduce the equity pricing if the company performs large secondary offering because of the overvaluation of stock.
I agree with the management of AMSC Company to take equity financing because of the advantages it offers to the company. The company has much to benefit from the equity-financing model of raising funds.
The cost of equity refers to the annual rate of return that an investor anticipates to get when he or she invests in the shares of a company. The return comprises of the dividends paid for the shares and the increase that comes with it in the market value of the shares. In order to determine the cost of equity of a company, three aspects must come into play. These include the return commensurate with risk-free security, a return incorporating the market risk in relation to the whole amount of stocks and a return that includes the business enterprise and financial risks that relates to the stock of the company itself.
The first determinant of return deals with the market rate of return currently available from a free risk security, for instance, the capitulate associated with long-term Treasury bond. If a treasury bond rates at ten percent, the investor should have a return more than ten percent for a common stock.
The second determinant of return involves the market returns currently present from the risks associated with stocks in general and the stocks themselves. One should put the price of the premium into any equity investment. For instance if one anticipates to earn nine percent on average, in the stock market and the free risk rate stands at six percent, the equity premium would be three percent. Equity risk premium equals return on market minus free risk rate (Weil, Wagner, & Frank, 2001).
The third measure that involves return versus risk relates to specific stock on the purchase. One determines the risk of the business and the risk of the financial structure or the advantage of the business entity. With greater risk, the company should have a larger risk as measured by variability of returns. With a greater advantage, for instance high debt to value ratio, in an increasing financial risk, the stock of a company should have a large beta. Therefore, in such a circumstance an investor should expect a better return.
The use of debt financing attracts a tax deduction. The interest that one pays on the loan attracts a certain amount of tax deduction. This means that it shields a portion of the income that comes from the business from taxes and lowers tax liability each year. The principle loan and interest paid once a company takes a loan acts as a business expense. Therefore, one should subtract the business expense from the calculation of business taxes. A business company benefits from the tax deductions attracted in debt financing.
The management of the superconductor company made the right decision to opt for equity financing because it would favor both the company and the investors. Both the equity financing and debt financing have advantages and disadvantages. The management of the company has the responsibility to decide the form of financing that will favor the company.