Raising Finance: Debt or Equity?

Many companies would not be the size they are without the need to raise finance, this can be done through equity or debt capital or through a mix of debt and equity in order to finance its activities.  However it is not as simple as just ‘raising finance’ and it is important that a company recognises the cost of the finance and the affect it may have on the business and the way the business is seen. Raising finance can be costly for both the firm and investors so a minimum rate of return is required in order to balance this out. Therefore the weighted average cost of capital (WACC) is indicative of the required rate of return that will give value to the company (The value pentagon as mentioned in Blog 1) and to earn these returns for the investors. The idea is generally to drive down the WACC to increase the market capital.

Raising capital through equity finance involves the company issuing ordinary shares. This could potentially raise a large amount of finance, the capital doesn’t have to be repaid and there is no legal obligation that the company has to pay its shareholders dividends, but volatile dividend payments often mean return is less than WACC.  However this does come at a high cost as it has a direct cost of issuing the shares and the cost of the return required to satisfy the shareholders. There is also a loss of control as the issue of shares dilutes the shares already in control by the company and the new shareholders have the right to exercise control over the company, vote at shareholder meetings and are entitled to a share in the rising prosperity of a company. In addition any dividends paid can’t be used to reduce the taxable profit as they are paid out after tax earnings which take a direct amount from the company’s baseline profit.

Equity can also be sourced globally and can be done so with added benefits for some companies as for their domestic stock markets can be highly illiquid, small and segmented so in doing so the liquidity of their shares are improved, provides a new and bigger market for new issues of shares and increase share price as visibility of the firm is increased. 

Capital can also be raised through debt finance for example a variety of bonds and bank loans. There is also the option for larger and more credit worthy companies to operate and tap into the Euromarkets. These companies that are large enough to use the Euro securities markets can out themselves at a competitive advantage compared to smaller firms as the finance can be available at a lower cost, there are fewer rules on these markets and national markets are often not able to provide the large amount of finance that may be required. Debt differs to that of equity as the lenders have no official control over the company which is an important factor for some companies for example Sir Richard Branson bought back £375m of Virgin’s shares as soon as the company’s profits increase. However debt does require regular cash outlays in the form of interest and the repayment of the initial capital sum, there is also less risk for the lenders as interest is paid before the dividends but is higher risk for the company but one that could generate more of a return than equity (risk/return trade off).

For many companies it is a choice that the managers of that company have to make when deciding on how to raise finance and often different countries favour different methods of financing for example both UK and US favouring equity compared to Germany and Japan favouring debt as their way of financing their activities.

One of the most recent companies in the news to raise finance was Facebook as it bought Whatsapp on the 19/02/2014 for approximately $16 billion, consisting of $4 billion in cash plus 184 million shares or approximately $12 billion worth of WhatsApp’s stock. Facebook chose to use equity finance as a way of raising this capital and had done so previously as in 2012 it filed for an initial public offering to be listed on the stock exchange. Facebook did so to raise $5billion to make it one of the largest IPO’s in internet history and to increase its membership and income as both were decelerating.

However the founder, Zuckerberg, managed to avoid the usual disadvantage of loss of control of the company that comes with share issue as in 2009 they instituted a dual-class stock structure to ensure that the early investors would retain control of the company and Zuckerberg was to own 57% if the voting shares and a 22% ownership in Facebook.

So is there a best way to raise finance…….