Securities issued by corporations to finance their projects may be classified roughly as equity securities and debt securities. There is a distinction between both the forms of financing. In its crudest level debt represents something that must be repaid; it is the result of borrowing money. When corporations borrow, they promise to make regularly scheduled interest payments and to repay the original amount borrowed (representing the ‘principal’) (Ross Westerfield Jaffe) Equity securities on the other hand represent the shares in the company.
“Equity is money that is received in exchange for a share of ownership in the business.” (Mark Minassian) The equity may take the form of common stock or preferred stock. Preferred stock represents equity of a corporation but it is different from common stock because it has preference over common stock in the payment of dividends and in the assets of the corporation in the event of bankruptcy.
Debt and Equity Financing – Differences: Differences between debt and equity are outlined below:
1. Debt is not an ownership interest in the firm. Creditors do not usually have any voting power. They protect themselves by incorporating necessary covenants in the loan contract. 2. The corporations’ payment of interest is considered as cost of doing the business and is fully tax deductible. Dividends on common and preferred stocks are paid to shareholders after the tax liability has been determined. 3. Unpaid debt becomes a liability of the firm and hence on non-payment a cause of action arises to the creditor to sue the corporation legally for the recovery of the sum due. This is not the case with equity.(Ross Westerfield Jaffe)
Kinds of Debt Financing: “Debt financing may take the form of bank loans, notes, debentures or bonds and bank loans.” Debentures represent unsecured bonds of a corporation. Alternatively the corporation may issue mortgage bonds which are secured by lien on specific fixed assets of the corporation” (James C. Van Horne). A bank loan on the other hand is offered as a term loan repayable over a period of time. For obtaining the bank loan the corporation may have to pledge the documents of title to its fixed assets as collateral security.
In addition the banks may insist on the personal guarantees of the directors for the prompt repayment of the loan by the corporation. Merits of Debt Financing: The major advantage of debt financing is that it is finite in nature that the business would be repaying it over a definite period of time making it a zero balance. Moreover the creditor who lends money to the business does not acquire any ownership over the assets of the company. Additionally the interest payable on the loans is fully tax deductible.
Demerits of Debt financing: The major disadvantage with debt financing is that the organization will have to arrange for a regular payment of interest and loan repayment every month depending upon the loan conditions from the creditors. This will become a burden on the company as it affects the cash flow of the organization. The other disadvantage is that the creditors may require the personal guarantees from the directors. Merits of Equity Financing: The equity financing does not give rise to any obligation on the part of the organisation either for the repayment of the equity or for the payment of the interest on equity to the investors. (Mark Minassian)
The other advantage with the equity financing is that the equity shareholders provide the organisation with their business experience and other lessons learned by them. They can also become trusted advisors to the company by becoming members of the Board of Directors. (Asheesh Advani) Sufficient cash flow will be maintained in the company as there will be no regular outflow on account of interest or principal for the loan.
Demerits of Equity Financing: The important disadvantage of equity financing is that there are other contributors to the capital who also expect a share of the ownership. (Tiare Rath) This dilutes the ownership of the company and results in lowering of the financial control and there will be constraints on making strategic decisions relating to the business issues as the shareholders need to be consulted in major decisions.
Decision for American Semiconductors: Tax advantages favour debt, but default and cash flow favour equity. From the control angle though the features of debt and equity are different one is not better than the other. Consider the major advantage from the tax angle and finite nature it is better to go in for debt financing. While resorting to debt financing there will be no dilution of ownership and control on the business remain in tact.
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