Introduction
There are several sources of external finance that are available to a company. A company can raise finance either through equity financing, bond financing, or bank finance. Each instrument of finance has its advantages and disadvantages. There are several things that the senior management must consider when choosing the instrument of external finance.
Equity Financing
A company may decide to float shares to the public to raise finance. There are several types of equity financing. It may decide to go public and conduct its initial public offering in the public market. The company issues out a prospectus detailing the history of the company, senior management, and the profitability of the company for five years. Approvals must be sought from the regulatory authorities to float the shares. The investors decide on whether to buy the company shares or not. The company then allots the shares to the people who have subscribed. The company may also conduct rights issues where the company issues out more shares in the market. The existing shareholders are given an option to exercise the right to buy the shares. The company may also decide to issue more shares in the market in the future to raise more capital.
Advantages of Equity Financing: It is a less risky form of finance. In bond financing, the company is obligated to pay interest payments and any default will cause the creditors to call for winding up of the company. For shares, the board of directors has the discretion of deciding whether to pay dividends or not depending on the
Profits earned and future investment projects
The company also has the flexibility of either paying cash or stock dividends. The company can decide to plow back the cash into the business and issue out common stock to the shareholders. The company can improve its debt-equity ratio when it issues common stock.
Disadvantages of Equity Financing: Interest payments are tax-deductible expenses in the income statement. Dividends paid to shareholders are not an allowable expense. There is dilution of control every time the company issues stock to the public. The new shareholders can influence the financial and operational direction of the company. Equity financing also decreases the earnings per share ratios of the company.
Bond Financing
A company may decide to issue long-term debt in the form of bonds. The bondholders are entitled to be paid a certain amount of interest rate on the bond’s par value. The interest payment may be once or twice a year.
Advantages of Bonds: The interest paid on bonds is tax-deductible, unlike stock dividends. There is no dilution of control of the company
It is cheaper than issuing stocks as there are no floatation fees involved.
Disadvantages: In issuing bonds, there are restrictive covenants that the company agrees to that end up controlling the extent of the company operation. Bondholders usually have restrictive covenants of different kinds. Some restrict the liquidation and acquisition of fixed assets. They do not want the company to engage in activities that may affect the company’s ability to repay the loan. The company may not be allowed to take up any additional debt.
Issuing bonds increases the leverage or debt ratio of the company. The company should be cautious to take up only debt that it can handle otherwise it will lead to bankruptcy. The interest payments to the bondholders have to be paid out. It is a mandatory payment. To monitor the leverage ratio of a company there are credit agencies that grade the company’s long-debt transactions. They highlight to the potential creditors in the market the leverage position of the company and the risks involved. The ratings are objective and can be upgraded or downgraded dependent on the actions that the company takes in the future. The ratings carry a lot of weight and can influence the creditors on the company’s image.
Hybrid Securities Financing
A company may also use hybrid securities to obtain external finance. The company may use convertible securities, preferred stock, or warranties.
Preferred Stock Financing
There are certain characteristics of preference shares that make it an attractive method of raising external finance. The company will issue shares that have a preference over the common stock in getting dividends from the company. When it comes to the liquidation of the company, the preference shares have a priority over the common stock when the company proceeds are being distributed.
In the event, the company does not perform well and the profits are insufficient, the company does not have to pay dividends to the preferred shareholders. Inability to pay the preference dividends cannot result in default or legal action. However, the preference shareholders’ dividends may be cumulative where the company is obligated to pay the pending dividends in the future.
There are redeemable and irredeemable preference shares. The redeemable preference shares are paid up by the company when the maturity period reaches. For the irredeemable shares, the company can use the cash raised till the company winds up or is liquidated. Preference shares may also be convertible securities where after a certain period the holders can convert the security into common stock.
Advantages of Preference Stock Financing: The company can raise more capital for the company without diluting the control of the company meetings. Preference stock financing works to lower the gearing or the debt-equity ratio of the company.
Disadvantages: The Company is obligated to pay fixed dividends regularly at a fixed rate to the shareholders. This may become a burden to the company in the future.
The convertible preference shares represent a dilution of control of the company. The market prices of the shares are also affected by the conversion of the securities.
Convertible bonds
The company may issue convertible bonds which are debt instruments that can be exchanged for another company’s security usually common stock. The advantage of this type of financing is that the interest rates are lower than the non-convertible loans. The disadvantage however is that it leads to dilution of control since the bondholder on maturity can obtain the common stock of the company and participate in voting activities.
Share Warrants
This is hybrid security where the warrants give the holder the right to acquire common stock from the company for a certain price within a set duration of time. It is the same feature that is present in convertible bonds. The main difference between the share warrants and the convertible bonds is that the holder of the share warrants pays out money to obtain the desired common stock. The warrants have the effect of diluting the earnings per share of the company.
There are three situations where the company issues share warrants to the public. The company may issue share warrants when issuing bonds or preference shares to entice or attract more parties to purchase the company’s securities. It acts as a deal “sweetener”. There are times when a company issues additional shares in the public market. The existing shareholders have priority in purchasing shares so the company usually issues share warrants to them. The company at times can also issue the share warrants to executive management to act as a form of compensation.
Advantages of Warrants
The company can issue preference shares and bonds at lower interest rates. The share warrants also make it easier for the company to raise external finance since they make the other securities highly attractive to prospective investors or creditors. The company can issue both equity and long-term debt at the same
time. There is a balancing of the debt and equity components in the equity structure causing the debt ratio to change by lesser margins. The company is also able to raise more money since when the share warrant holders exercise their rights they have to pay the exercise price.
Disadvantages
There are however certain disadvantages in exercising share warrants. When the share warrants are exercised, it shows that the common stock has been diluted. The market price of the company shares reduces significantly. With an increase of the common shareholders, there is the dilution of control as they have the right to vote and influence the operations of the company. The share warrant holders may also exercise the share warrants at a time when the company does not require additional capital. The company’s management will have to decide quickly what to do with the excess cash to ensure the excess liquidity is used in profit-generating activities.
Chesapeake Senior Notes Issue
This is a company situated in the United States in Oklahoma City. It produces natural gas and is the second-largest producer in the United States. In February 2011 the company issued $1 Billion worth of unsecured senior notes. The coupon rate for the bond is 6.125%. The par value or the coupon rate of the bond is $100. The bonds will mature on 15th February 2021. The first payment of interest was on 15th August 2011.
The interest payments will be twice a year throughout the bond’s ten-year life. The yield rate of the bond is also 6.125% which is the same as the coupon rate.
Unsecured notes refer to debt that is not attached to the company’s assets.
They are issued at high-interest rates to compensate the investors for the lack of security. The company issued the senior notes to pay revolver borrowings. Bonds are rated by credit agencies to inform the public and protect their interest.
Where the notes are classified as senior notes this refers to notes that have priority over the common and preferred stockholders in the event of liquidation. Notes may either be secured or unsecured. The secured notes will have priority over the unsecured notes since they have the corporate assets as collateral.
The bond issue was rated by Moody’s Investor Service at Ba3. This is a positive outlook and the rating company gives the factors that influenced the rating. The company has a very large and diversified property base. However, the rating is restrained by the fact that the company is highly leveraged.
Looking at its past financial performance, it has an aggressive growth and complex capital and financial structure. The company has also announced annual plans of reducing its leverage ratios. It will reduce its production growth volumes to achieve a rating of Ba1. The rating company will only upgrade the company when the leverage ratios go down and the company shows the ability to sustain the improved leveraged ratios and capital discipline.
S & P graded the bond issue at BB. However, in April 2011, the company upgraded the rating to BB+. The company had just sold a substantial amount of its assets. It sold the Fayetteville Shale assets for $4.6 Billion to BHB Billiton Limited on March 31, 2011. The Company is expected to utilize the sales proceeds to settle part of its debt which will reduce its leverage ratios.
There has also been high production of gas despite the weak or decreasing prices in the market. The rating was also made possible by the company’s competitive strengths. It has a large drilling inventory and a great and impressive history record in exploration. Although the company in recent years has been increasing its gearing, it has a large and rich asset base that gives it funding flexibility since most of the assets are unencumbered.
The rating company removed the company from the CreditWatch list however it does not foresee a further upgrade of the rating shortly. The company’s leverage policy is fairly aggressive and it involves itself in high capital spending. The high capital spending is expected to affect the internal cash generated by the firm significantly. It also announced tender offers for its long-term debt of $2 Billion. Tender offers are transactions where the company offers the debt holders an opportunity to have the debt retired. These actions are following the company’s long-term plan to reduce its leverage ratios.
As of 2010, the company’s long-term debt stood at $12.64 Billion. By the end of 2012, the company hopes to have reduced its long-term by 25%. The company will also reduce its growth production target by 25% for the period 2011-2012. The outlook of the company according to S & P is stable. The company should however, ensure it accomplishes its plan to reduce the leverage ratios. It should also consider moderate financing and growth strategies.
Flitch credit agency had graded the company as stable however in May 2011; the agency upgraded the rating to positive. The factors that influenced the upgrade were the same ones cited by the other credit agencies. The company’s plans to reduce debt and aggressive capital expansion have been received positively. The energy company also wants to increase its oil production which will diversify the cash inflows instead of major reliance on natural gas production.
In analyzing the credit rating agencies’ comments on the company, the advantages, and disadvantages of using long-term debt come out. Investors and creditors are concerned about the leverage ratios of companies and as they increase, they will either demand restrictive covenants or higher rates of return. The rating agencies are concerned with the cash flow management and liquidity of the company. Unwise decisions on debt can cause a company to fail to pay the interest rates leading to its liquidation or winding up.
The company prefers long-term debt for certain reasons more than equity financing. It could be that it does not want to dilute the ownership of the company. There are also costs in obtaining equity finance that it avoids such as flotation costs. The rating companies however advise the company to tread slowly and cautiously when it comes to taking up more long-term debt. As it issues senior notes, other creditors of the company are watching and interested in securing their interest.
Conclusion
A company has the flexibility to choose the source of external finance that it should utilize. It has to weigh the pros and cons. How will it affect its liquidity and asset growth in the future? How will the control of the operations be in the future? The effect of the change of capital structure on the operations of the company in the future needs to be considered. Overall, a company should have a healthy leverage ratio.
References
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