Essay on "Equity and Debt"

Essay 3 pages (1045 words) Sources: 2 Style: APA

[EXCERPT] . . . .

Equity and Debt

Capital structure decisions are generally considered to be major decisions by managers, because they impact the firm in a number of ways. Public firms seldom issue further equity because it has a higher cost than do debt issues and because it results in a dilution of ownership, but there may be strategic considerations that compel management to issue equity after the IPO.

One of the major considerations that must be considered when a firm tries to decide how to raise capital is the issue of cost. In general, equity has a higher cost that does debt. Debt issues, by virtue of having a set, guaranteed payment, are viewed to have lower levels of risk. Equity issues have no guaranteed payments -- indeed returns of any sort are not guaranteed -- and this makes them riskier investments. Because risk is typically correlated with return, the return to investors must be higher to compensate for the increased risk. Therefore, the cost of equity is typically higher than the cost of debt. The firm's cost of capital is often a consideration in capital budgeting decisions. A firm with a high cost of capital can only use that money to engage in relatively risky projects that will have higher expected returns. Firms with a lower cost of capital have more flexibility to take on safer projects. The result is that the more debt a firm carries, the safer the projects it can take on.

The firm's total risk does not change despite its capital structure. This means that while debt is lower risk for investors, it is higher risk for the company and its shareholders. A firm with a high debt level is said to be highly leveraged. Remember that debt represents an obli

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gation to pay the debt holder. The higher the amount of the firm's earning must be paid out to the debt holders, the greater the risk to the firm. Therefore, a firm with a high degree of leverage is said to have a high degree of risk. If its cash flows become compromised, it can experience reduced liquidity or even solvency. Management must therefore consider its current and future debt levels when deciding on the best means to raise money (Hillstrom, 2010).

Another consideration is raising capital in the future. Firms with high debt levels may find it difficult to raise money in the future, because of the risk that they have. Equity investors would be subordinated to the high debt, and other debt investors would also see the high risk inherent in a highly-leveraged company as cause for concern (Hillstrom, 2010).

The decision of American Micro Semiconductor in 2003 to undertake an equity issue instead of a debt issue must be examined in the context of the company's financial situation and competitive situation at the time. The company's cash flows were expected to grow with stability as the Northeast blackout highlighted the need for utilities to modernize, which would give AMSC more business. The company also had a growing presence in the perpetually-expanding Chinese market (Esposito, 2003).

One of the factors that guided this decision was the strength of… READ MORE

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Quoted Instructions for "Equity and Debt" Assignment:

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American Superconductor

As you know from reading through the background materials, the decision to use debt or equity to raise money is not a decision taken lightly by management. So when several years ago, in 2003 American Superconductor decided to raise funds through equity it was definitely a major decision that required intense discussions at the highest levels of management.

Read the article below about American Superconductor and do some of your own research using the CyberLibrary and internet search engines. You can also take a look at the official American Superconductor webpage. After doing your research, apply what you learned from the background materials and write a three to five page paper answering the following question:

What are the advantages and disadvantages for AMSC to forgo their debt financing and take on equity financing? Do you agree with their decision?

Explain both of your answers thoroughly. Be sure to support your opinions on these assignment questions with references to the background materials or to other articles in your paper.

Read the article below available in Proquest:

American Superconductor switch ; Westboro company plans to raise money through a stock offering

Andi Esposito. Telegram & Gazette. Worcester, Mass.: Aug 26, 2003. pg. E.1

Abstract (Article Summary)

"AMSC's management and board of directors believe the decision to forgo a secured debt financing and to adopt an equity financing strategy under current market conditions is in the best interests of our shareholders," said ***** J. Yurek, chief executive officer of AMSC. The 265-employee company has operations in Westboro and Devens and in Wisconsin.

Finally, the Northeast blackout "shined a lot of light on the problems we have been talking about as a company for three to four years," Mr. Yurek said. AMSC products, such as a system installed this year in the aging Connecticut grid and high temperature superconductor power cables and other devices bought by China for its grid, are designed to improve the cost, efficiency and reliability of systems that generate, deliver and use electric power. "We are a company with products out there solving problems today," he said.

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