Companies use various financing methods to fund operations and growth. Equity and debt are the main sources, with offering a hybrid option. Each type impacts the company's cost of capital differently, affecting its overall financial structure and performance.
New equity issuance can increase costs and dilute ownership, while offers flexibility. Alternative methods like private equity, , and provide unique benefits. Understanding these options helps firms make informed financing decisions to support their goals.
Equity and Debt Financing
Return required by preferred shareholders
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Preferred shares offer investors a fixed dividend payment prioritized over common stock dividends
Lack voting rights typically associated with common shares
Required return on preferred shares calculated using the formula rp=P0Dp
rp represents the required return on preferred shares
Dp denotes the annual preferred dividend per share (e.g., $2 per share)
P0 signifies the current market price per preferred share (e.g., $50 per share)
Calculation of WACC with preferred shares
WACC reflects the blended cost of a company's various financing sources equity, debt, and preferred shares
Each financing component weighted by its proportional contribution to the overall capital structure
WACC formula incorporating preferred shares: WACC=wdrd(1−t)+were+wprp
wd, we, and wp represent the weights of debt, equity, and preferred shares, respectively (e.g., 40%, 50%, 10%)
rd, re, and rp denote the costs of debt, equity, and preferred shares, respectively (e.g., 6%, 12%, 8%)
t signifies the corporate tax rate (e.g., 25%)
To include preferred shares in WACC calculation, determine their weight in the capital structure and required return
Equity Issuance and Convertible Debt
Impact of new equity on cost of capital
Issuing new equity can potentially increase a company's cost of equity capital
New equity dilutes existing shareholders' ownership stake and control
May signal management's belief that the stock is currently overvalued
Increased supply of shares in the market can exert downward pressure on the stock price (supply and demand)
Lower stock price translates to a higher cost of equity capital due to their inverse relationship
Companies must carefully assess the timing and necessity of new equity issuance to minimize negative impacts
Features of convertible debt funding
Convertible debt combines characteristics of both debt and equity financing
Issued as debt with a specified and maturity date (e.g., 5% coupon, 5-year maturity)
Grants bondholders the option to convert the debt into a predetermined number of common shares (e.g., 10 shares per bond)
Benefits for the issuing company:
Lower compared to traditional debt due to the embedded conversion option
Delayed of ownership until bondholders exercise their conversion rights
Attracts investors seeking potential equity upside while maintaining downside protection
Benefits for investors:
Opportunity to participate in the company's growth prospects through the conversion feature
Fixed income payments and principal repayment if conversion is not exercised
Downside protection in the event of company underperformance or bankruptcy
Alternative Financing Methods
Private Equity and Venture Capital
Private equity firms invest in established companies, often through leveraged buyouts
Venture capital firms provide funding to startups and early-stage companies with high growth potential
Both offer expertise and guidance to help companies grow and increase value
Mezzanine Financing
Hybrid form of financing that combines elements of debt and equity
Typically used to finance expansion or acquisitions
Offers higher returns than traditional debt but less dilution than equity
Crowdfunding and Angel Investors
Crowdfunding platforms allow companies to raise small amounts from a large number of individuals
are wealthy individuals who provide capital to startups in exchange for equity or convertible debt
Both methods can be particularly useful for early-stage companies or niche projects
Other Financing Options
involves selling accounts receivable to a third party at a discount to improve cash flow
Companies can also consider leasing equipment instead of purchasing to preserve capital