American Superconductor offers a wide range if technologies and solutions related to the electric power infrastructure from power generation to deliver to end use. AMSC is the leading firm in renewable energy, providing wind turbine designs and electrical control systems. The company provides a range of Smart Grid technologies for power grid operators that are used to integrate renewable energy sources into the power infrastructure. AMSC’s Decision to Forgo Debt Financing: Both debt financing strategy and equity financing strategy have their pros and cons when it comes to fulfilling the financing needs of the company.
The main concern of the management while making capital structure decision is the cost of capital. The management of American Superconductor feels that the equity financing will be a cheaper source of finance for them in the current market conditions and it is also in the best interests of Company’s shareholders. The company’s management had earlier communicated it to shareholders that it planned to raise $50 million through debt financing but then changed their plan in favor of equity financing. 1. Advantages for American Superconductor to forgo their debt financing and take on equity financing:
The biggest advantage of using equity financing strategy to fulfill company’s financing needs for the American Superconductor would that the company will be under no obligation on them to repay the money raised. Moreover, the company will also not have to pay interest payments on $50 million loan. The interest payments would otherwise reduce the profits considerably and as a result company would have been less profitable. American Superconductor will not have to pay any penalties if it fails to pay dividends to the shareholders of the company.
If the management decides that it needs to reinvest the profits it earned rather than distributing it to the shareholders as dividends, it can do so without being liable for any further penalties on non-payment of dividends. Whereas, the company will be faced with severe penalties using a debt financing strategy, if it fails to repay the principal amount of loan or pay interest payments regularly. One of the many advantages for taking on equity financing is that would help in keeping the debt to equity ratio to a lower level.
The higher gearing level increases the risk profile of the company and as a result the investors demand a higher return for their investment in the company’s stock. The company’s move towards the equity financing strategy will help lowering the gearing level and risk profile of AMSC. (Damodaran. 2007). In debt financing, the lenders often impose restrictions and limitations on the company’s activities, preventing management from considering alternative financing options and diversifying its operations.
In contrast, there are no such restrictions and limitations when raising finance through issue of company’s stock. All that is required by the investors is an attractive return on their investment in the company. Debt financing may also create cash flow problems as there have to regular payments of interest and principle amount. This requires the company to allocate a certain cash reserve for repayments to the lender, thereby, requiring more and cash. While in equity financing, AMSC can avoid paying dividends to shareholders for a certain period or even paying bonus shares instead of cash dividends.
If AMSC raised $50 million through debt financing, it may have had to pledge company’s assets as collateral to the lender, which gives the right to the lender to sell of those assets pledged as collateral if the borrower fails to repay the loaned amount. Whereas, in equity financing AMSC wont have to pledge any of its assets as collateral. In case of liquidation of the company, the equity financiers are to be paid in last and they are not entitled to anything in case a company goes bankrupt. 2.
Disadvantages for American Superconductor to forgo their debt financing and take on equity financing: The use of equity financing will cause the company’s owners to loose some control of the business to new equity holders. If the new investors have different ideas about the company’s strategic direction or day-to-day operations of the company, then that can create a conflict between the management and investors. In contrast to that, the debt holders cannot share the ownership rights of the company.
The lenders are entitled to only interest and principal repayments of their loaned amount and have no direct claim on future profits of the business. If AMSC earns more and more profits, it will have to share those with the equity holders in form of dividend payments. If the company does not pay the dividends to equity holders regularly enough, than it might result in the depreciation of company’s stock price as the investors are only interested in companies which offer a good rate of return.
Another major disadvantage of forgoing debt financing in favor of equity financing is that the interest payments payable on debt is an allowable expense when calculating the taxable profits and reduces the cost of the capital. While the dividends payments is not an allowable expense for tax purposes. This means that the company would have been able to reduce its tax expense if it raised $50 million through debt financing. These savings from interest payments add value to the company and also save the cash outflow resulting from the reduced tax expense.
The interest payments and principal repayments are usually known amounts except in the case of variable rate loans, which make it easy to forecast and allocate the budgeted amount for it. Raising debt financing is less complicated than the equity financing because AMSC won’t have to comply with the state and federal security laws and regulations. The change in strategy by AMSC for raising money through equity financing might create complexities in the decision-making process, as the management will have to take the approval of shareholders through their votes when making key decisions regarding the business.
Conclusion: It seems that despite of the many benefits and advantages that the debt financing may infer, the change in strategy by the management of American Superconductor to fulfill their future financing needs through use of equity financing, is a suitable strategy. This change in strategy will help in reducing the risk profile of the company. It is also seen that the company’s share price is on the rise, so it is the best time to capitalize on that and raise finance when the market conditions are favorable for the company.
References:
amsc. com n. d. About American Superconductor (NASDAQ: AMSC).Retrieved May 31, 2010. from http://www. amsc. com/investors/index. html Damodaran. A. 2007. n. d. Debt-Equity Trade Off: Stern School of Business, Retrieved May 31, 2010. from http://pages. stern. nyu. edu/~adamodar/pdfiles/ovhds/ch7. pdf Harvey, C. 2002. How do CFOs make capital structure and budgeting decisions. Retrieved May 31, 2010. from http://faculty. fuqua. duke. edu/~jgraham/website/SurveyJACF. pdf referenceforbusiness. com/. n. d. EQUITY FINANCING. Retrieved May 31, 2010. from http://www. referenceforbusiness. com/small/Eq-Inc/Equity-Financing. html