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Concepts of Debt and Equity Relations

Financing decisions are some of the major decisions that the management of a company must make. There are two sources of capital for any company, they are debt and equity financing. According to Gotthilf, (1997), “Debt financing; a company acquires new capital by borrowing from external sources i.e. by paying a price called interest on the borrowing.” On the other hand, Damodaran (2007) claims that “Equity financing a company obtains its capital financing from the existing shareholders who are the owners of the company either by floating new shares or by reinvesting the retained earnings.” The major consideration in the choice of financing is the cost of obtaining the additional funds together with the expectations and the legal requirement.

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The company is faced with the challenge of expansion of its operations in order to meet the high power demand. It is also of concern for the company to realize earnings considering that the previous losses that the company has incurred are a threat to its going concern. The management is therefore in a bid to correct the negative earnings of the company by acquiring additional capital to enable it to expand and improve its efficiency.

In the year 2003, the management of AMSCS decided to raise funds through equity financing. The reasons that might have propelled the company in the above financing means are: Equity financing was considered the cheapest source of financing given that debt interest would be high. Debt holders would charge high-interest rates because of the risk of repayment as the company realized losses. The additional risk could only be accepted on the condition that the price is high. The management, therefore, was justified in adopting this source of financing

Equity financing is also prompted by the desire to retain control. The shareholders of the company will not prefer the conditions that are associated with the debt capital. Most debt capital is given on the condition that the amount is invested in a particular manner and this would not augur well with the shareholder’s plight. The management, therefore, was justified in issuing equity financing and not debt.

The third factor that prompted the management of AMSC to prefer equity is also to reduce the risk of the company being insolvent and hence taken into receivership. This would be as a result of the company not being in a position to meet its maturing obligations as they fall due. Due to this, the debt holders would be in a position to bring a liquidation case against the company and therefore terminate its operation. The management, therefore, was right in equity financing.

The desire to reduce the expenses of management is as well a factor that instigated the management decision.interest expenses that would be paid to the bondholders would reduce the operating profits and therefore increase the losses of the decision was therefore driven by the urge to prevent further increase in the losses of the company.

In the capital decision, con sudations must also be given to the government regulations. In some cases, the government restricts the proportion of debt-equity ratio that should be followed by the company. The objective of this regulation is to reduce the risk of gearing of a company and also to ensure that the capital adequacy requirement is adhered to. The management is therefore intending to reduce the gearing level by increasing the proportion of equity on the capital ratio. It could also be aimed at correcting the required capital ratio of the company.

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In as much as the decision of the AMSC management is justified in this perspective, there are several factors that ought to have been integrated into the financing decision. To begin with, the management would have considered other cheaper means of obtaining debt. This source would therefore result in a reduced marginal cost of capital hence maximizing the shareholder’s worth. Again it is important to note that debt financing is subjected to tax shield benefits. The interest which is the price paid for borrowed money is considered as an expense hence deducted from the operating profit thereby reducing the profit on which tax is levied. This view would have increased the value of the firm in the long run.

The idea of issuing new shares would also reduce the control of the existing shareholders by having new owners. Debt financing ensures that the control by the existing shareholders is retained since bondholders are not owners and therefore do not participate in management. Equity financing may also result in an increase in retained profits which may compromise the need of shareholders to get dividends as a return for their investments. Debt financing solves this problem by providing external funds hence allowing the company to pay prompt dividend returns.

Moreover, the conditions that are associated with debt finance would ensure that the management improves its managerial decisions. Bankers and investors who offer their loan services always provide professional advice to the company making sure that they conform to the objectives and enhancing their corporate governance. Apart from this, the formalities for obtaining debt are simple and faster compared to the issue of new shares. When issuing new shares, various costs are to be incurred i.e. when raising new shares the floatation cost was incurred by AMSC Company. This cost is high compared to the cost of obtaining debt.

Peterson (1999) argues that other reasons for debt financing may include inter alia the incapability of the existing shareholders to exercise their rights in a rights issue. Again, the fact that the company is realizing losses would mean that debt financing would be not a viable way of obtaining finance. The management of AMSC was therefore faced with the tough decision of selecting between debt and equity finance.

In conclusion, I would support the decision of the management of AMSC to prefer equity to debt financing. This is the best way it could obtain the finance and expand on its activities of generating energy in the United States (Harvey, 2002). The importance of the activities of the company is crucial to the economy of the state and therefore the government interest in the performance is also justified. The company’s further decision to acquire some profit-making firms i9s is also a good decision as it minimizes the loss that results from the company operation. The idea also helps to diversify the company’s activities which would mitigate the future losses anticipated.

Finally, the growth of the company in the future operation is indispensable as it plays a major role in the economy. This future existence and growth would in the long run impact positively on the earnings of the firm. Capital structure decisions are therefore important as huge capital projects which are irreversible are made. It requires competent management and prudent decisions for success to be realized.

Reference list

Damodaran, A. (2007). The Debt-Equity Trade Off: Stern School of Business. Retrieved August 2, 2007 from: Capital Structure Decision.

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Gotthilf, D. L. (1997). Long-term borrowing techniques. Treasurer’s and Controller’s Desk Book. American Management Association.

Harvey, C. (2002). How do CFOs make capital structure and budgeting decisions. Retrieved August 1, 2007 from: Journal of Applied Corporate Finance, 15(1), 8- 23.

Peterson, P. (1999). Analysis of Financial Statements. New York: Wiley.

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