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Companies can use internally generated funds or external funds to finance business operations and projects. It is therefore important that the company utilizes the cheaper source of financing so s to maximize shareholders wealth. Internal sources of finance include cash, factoring and retained earnings while examples of external sources are equity, bank loans or bonds issue. External Financing Business financing through internal funds is usually not adequate and therefore companies are forced into looking for other sources of funds, which are usually external.
External funds are basically in the form of equity and debt (Candid Capital 2008)
This basically represents the owner’s interest in a company. Equity can be in the form of ordinary (common) or preference shares. Equity represents the net assets of the company i. e. after all liabilities have been deducted. In raising capital from equity, the company can issue shares to existing shareholders, new shareholders, venture capitalism, business angels or merchants banks. The issue of shares to already existing shareholders is basically through a rights issue where the company discounts offering price (Candid Capital 2008).
Venture capitalists are generally outside investors who provide funds in exchange for ownership in the management of the company.
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Venture capitalists can also demand representation in the management of the company. Examples of venture capitalists include venture capital funds, investment banks, wealthy individuals etc. This form of equity financing is however, limited to new or young companies that still cannot access funds from the market (Candid Capital 2008). Business angels are another form of equity investment available to new companies.
Merchant bank is also an option in financing investment projects.
Equity holders always invest in the long-term and therefore they will not abandon the company if it makes losses. Equity holders are interested in the long-term survival of the company and may even provide extra funds in case it is needed by the company. Equity financing may bring into the company the skills and (experience) of some venture capitalists or business angels therefore benefiting the company with funds as well as skilled management (National Food Industry Strategy 2008).
Since equity inventors only receive returns when the company makes profits, then, they are interested in ensuring that the company is profitable.
The process of raising finance through equity is costly and takes time in terms of approval and arranging. This means that the investment project may be lost while the company is still trying to raise funds. The presence of business angels or venture capitalism brought aboard the company through equity financing may lead to a change in the strategies thereby leading to the company adopting different strategies (National Food Industry Strategy 2008).
Apart from the strict regulatory conditions that must be met by the issuing company, it must also provide the equity holders regular updates about the performance of the company thereby increasing costs of running the company. The issue of extra shares to raise funds will lead to the share price of the company dropping. This is because the demand and supply forces in the market (Business link 2008)
This is where the company secures funds through the issue of bonds, debentures, notes and the traditional form of debt, which are the bank loans.
Debt financing can be short-term or long-term; short-term is debt repayable within 1-5 years while long-term takes a longer period of time e. g. 5-10 years. This form of business financing is usually less complicated than equity as there is less regulation to be complied with. Debt financing also involves the process of arrangement, which carries some costs and also takes time. Advantages of Debt The cost of debt is usually cheaper than that of equity. This is because the interest on debt is normally tax allowable therefore reducing the taxable income of the company.
Equity investors on the other hand demand a premium on the returns for taking the risk of involving on the project (Business Finance 2008). The costs involved in arranging a debt are also far much less than equity and thus the company is able to acquire cheap capital at lower costs. Debt financing due to its constant returns is attractive to investors and therefore the problems of e. g. under subscription may not be witnessed. The use of debt reduces the company’s tax burden and therefore investors are able to earn more.
Debt financing can therefore be seen to enhance the returns of equity holders (University of Akron 2008) Disadvantages Debt financing involves the repayment of interest and principal amount on a regular basis despite the performance of the company. This means that if the company makes losses, it may have difficulties in servicing the debt. In the case of bank loans, guarantees are required and this may lead to loss of thee assets in case of defaults. The use of debt in the company is only beneficial up to some point with which further use of debt increases the financial risk of the company.
Also the agreement governing the debt may affect the use of the company’s assets. E. g. the secured assets may not be used without the consent f the debt holder. This therefore may negatively impact on the productive use of assets (Business Finance 2008). Recommendation Based on the characteristics of equity and debt financing, I would recommend that the company utilize both sources of funds to finance the project This is because the use of equity ensures the continued shareholders support in terms of extra funds and their desire for the project to succeed.
The use of debt on the other hand enables the company to acquire cheaper financing which has tax benefits. The use of debt also enables the management to achieve shareholders wealth maximization, which is their main objective.
Financial Aspects of Acquisitions. (2020, Jun 02). Retrieved from https://studymoose.com/financial-aspects-of-acquisitions-essay
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