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Example of essay on debt and equity

Advantages and disadvantages of equity financing

Advantages
One advantage of equity financing is that AMSC will not be forced to make any regular payments to shareholders. Equity holders in the company benefit through dividends and capital gains that arise from the appreciation of shares of the company. Corporations do not have an obligation to pay dividends to its shareholders. AMSC will only pay dividends to its equity holders if the company makes a profit. The rules for capital maintenance stipulate that companies should pay dividends out of distributable profits (Baker & Martin, 2011). It implies AMSC will not make any distributions to shareholders if it does not make a profit. On the other hand, debt involves periodic interest payments whether the company makes a profit or not.
In addition, share capital provides a permanent source of finance to the company. Unlike debt instruments that have maturity periods, share capital remains in the company until the liquidation of the company. Therefore, equity is suitable for financing long-term projects and those with indefinite periods.
Moreover, equity does not have restrictive covenants that limit further borrowing of by the company and investment in some projects. Debt holders may impose restrictive covenants to prevent the company from further borrowing as it increases the financial risk.

Disadvantages

Equity financing does not help the company in reducing its tax expense. Dividends paid to shareholders are not allowable expenses for purposes of taxation (Baker & Martin, 2011). In fact, dividends paid by the company are subject to double taxation. Contrary to share capital, the use of debt lowers the income tax expense of the company since interest expense is tax deductible.
AMSC will incur higher floatation costs in issuing equity than debt. It increases the cost of equity for the company thereby lowering its market value. In addition, raising equity involves a longer procedure as the company must adhere to several statutory requirements.
Equity financing also dilutes ownership and control in the company. The new shareholders are entitled to control and voting rights in matters relating to the company. In addition, the company’s earnings per share is diluted hence the current shareholders will earn less than their initial earnings per share.

Decision of AMSC to go for equity financing

I strongly agree with the company’s decision to finance its projects through raising additional equity. As indicated, the company had entered into several and long-term contracts, including a contract with the US Department of Energy. Such long-term contracts are better financed through equity since it is a permanent source. In addition, the company may be forced to borrow in the future in order to finance several multimillion projects. Raising equity will not restrict the company from future borrowing. It will also increase the company’s earnings as it will not have an obligation to pay dividends.

Tax effect of debt

The use of debt lowers the income tax expense of the company. This is because interest debt is an allowable expense hence it reduces the company’s taxable income and hence the tax liability. On the other hand, dividends are distributions to shareholders and are paid out of profit after tax. Therefore, dividends are not tax deductible.

Determining the cost of equity

The Dividend Yield Model is used to determine the cost of equity by dividing the dividend per share with the market price per share. In case the company incurs floatation costs in raising stock, the fee is deducted from the market price.
Cost of equity when there is no growth in dividends = D0P-FC

Where P is the market price and Fc is the floatation cost.

If there is a constant growth in dividends, cost of equity is determined as follows:
Cost of equity = D0 (1+g)P + g. where g is the annual dividend growth rate.

References

Baker, H. K., & Martin, G. S. (2011). Capital structure & corporate financing decisions theory, evidence, and practice. Hoboken, N. J.: John Wiley & Sons.

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