Advantages and Disadvantages of External Financing Options – Case Study Example

Download free paperFile format: .doc, available for editing

The paper "Advantages and Disadvantages of Equity Finance" is a good example of a case study on finance and accounting. The financing decision of any project is very important to be considered before you reach a conclusion. The capital structure of the firm should be such that the Weighted Average Cost of Capital (WACC) should be less than your expected rate of return of the project in order to make a profitable investment. There are basically two sources of external financing which can further be subdivided. These include: 1. Debt financing2.

Equity financingDebt financing includes bank loans, debentures, overdraft facilities, hire purchase, line of credit from customers, and leasing. Debt financing means taking out a loan that has to be paid over a certain period of time with interest. There can be short term (loan is to be repaid in less than a year) or long term (debt is to be paid in more than a year) debt financing. These are called debt financing because the company is in debt to the bank or any other financial institution and if they go bankrupt example in the case of debentures, then the financial institution has a claim to the remaining assets of the firm. Equity financing includes the issuance of shares.

Shares are units of investment in a limited company be it a public or private limited company. The shareholders are called the owners of the firm as they own a percentage in the firm. Two types of shares can be issued in equity financing, ordinary shares, and preference shares. Advantages and Disadvantages of external financing optionsDebt FinancingThe first and the foremost advantage of any debt financing option is that you retain the control of the firm.

There is no loss of ownership to any external person. Therefore you can have all the profits and not have to distribute it to anyone. Secondly, using debt financing, the interest you repay on your loan is tax-deductible. This means that it protects part of your income from the taxes and thus lowers your tax liability every year. As there is no ownership loss, therefore you do not have to share the profit of the company to anyone.

Therefore all the profit is earned by the owner of the organization. All you have to do is to make timely loan payments to the creditors in a timely manner. The disadvantages of debt financing are that it causes an increase in the bankruptcy risk of the organization. The more debt financing you uses the more chances of bankruptcy. The risk of bankruptcy increases the cost of debt. The higher the bankruptcy risk, the higher the promised return will be asked by the debt holders. This increase in bankruptcy risk also reduces the free cash flows of a firm.

With higher bankruptcy risk, customers may prefer to buy from another company which directly affects the sales. This, in turn, decreases the net operating profit after taxes thus reducing free cash flow. Debt financing increases the cost of the stock. As debt is a fixed cost to a company, the fixed claims of the debt holders cause the residual claims of the stockholders to become less certain and this increases the cost of the stock. You can also lose your personal assets in debt financing in case of bankruptcy.

Equity financing The advantages of equity financing are that firstly, you can use your cash and that invested by the investors to run the business daily operations instead of making fixed loan payments every certain period of time. Secondly, at the time of liquidation, equity financers are to be paid last if some property or valuables are remaining but on bankruptcy, there are not paid anything. Equity financing also helps you boost the credit rating of the firm. With equity financing, the interest of both the financer and you are the same that is growth, profitability, and an increase in the value of the firm.

One of the major disadvantages of equity financing is the loss of ownership control. Depending upon the portion of investment by the shareholders, they have a say in the management and thus decisions might not be solely made by you. Raising equity financing is demanding, costly, and time-consuming especially for large MNE like Acme. There can be legal and regulatory issues to comply with when raising a large amount of equity finance as is the case with Acme who has to raise $500 million.

RecommendationsAcme should use a combination of debt and equity financing. This is because Acme has to raise a hefty amount of money. Also, just having debt does not give a good indication about the company and increases the bankruptcy risk and has high leverage whereas having just equity will cause loss of ownership to a large extent. Having a combination of debt and equity also gives you a better weighted average cost of capital.

I would suggest a ratio of 60:40 that is 60% debt and 40 % equity so that the tax benefit from having debt can be earned as well as some repayment of the loan is also reduced due to the equity. For debt, the company should issue debentures and ordinary shares for equity through stock markets.

References

Sources of finance. Bized. Retrieved (2010, May 25) from http://www.bized.co.uk/learn/accounting/financial/sources/index.htm

Peavler, R. (n.d.). Debt and equity financing. Retrieved from http://bizfinance.about.com/od/generalinformatio1/a/debtequityfin.htm

Advantages and disadvanteages of equity finance. (n.d.). Retrieved from http://www.businesslink.gov.uk/bdotg/action/detail?r.s=sc&r.l1=1074404796&r.lc=en&r.l3=1073864776&r.l2=1074404799&r.i=1075081686&type=RESOURCES&itemId=1073789573&r.t=RESOURCES

Download free paperFile format: .doc, available for editing
Contact Us