BUSINESS FINANCING AND THE CAPITAL STRUCTURE 7
BUSINESSFINANCING AND THE CAPITAL STRUCTURE
Debt vs. Equity: The Best Wayfor Financing BusinessIntoday’s economy, the choice of financing business is very criticalfor projected business expansion. Often, business owners are taskedwith making tough choices between taking a loan and arranging forequity financing of business. This choice is not only a challenge forsmall businesses but also large business owners seeking to expandtheir enterprises the choice of financing business alternate betweenseeking investors partnership or applying for business loan. However,business owners need to critically assess the merits and demerits ofeach alternative in order to select the most effective means offinancing their business (Mishkin,2012).Financing business throughEquityThischoice looks enticing on paper and in practical terms but it has itsshortfalls. Arranging with an investor for business expansion fundingappears a perfect choice for many business owners who detest debtrepayment most see equity as easy money for business expansionwithout any hassles of interest and repayment (Mishkin,2012).However, it is not free money as such business owners must dividetheir enterprise returns with the financiers or venture investors.Merits of financing businessthrough Equity:
Have less hassles than applying loan better choice if you cannot afford to pay loan.
The business taps into the investors’ network this enhances more credibility on the enterprise.
Most investors do not expect sharing returns on investments immediately long-term view.
Business owners do not need to stress in channeling profits to loan repayment.
More cash is held in hands for business expansion.
It is rare for investors to demand back their money if business fails.
Demerits of financing businessthrough Equity
In some aspects, investors may demand higher rates of returns than which could have being paid for loan.
More business control is given to the investor (financier) investor demand business ownership and part of profit which may not be good for small businesses.
Financiers have to be constantly consulted before making major business decisions and in some cases business owners disagree with their decisions.
In case of irreconcilable disagreements with financiers, business owners part with portion of their business or allow investors run the business.
Great effort and time is required to get the right investor.
Debt FinancingUnlikethe investor business owner relationship that exists with equityfinancing, the relationship that exists with loan advancers isfundamentally different there is no giving up part of the businessor sharing profit. However, too much debt could stall business growth(Mishkin,2012).Merits of financing businessthrough debts
The lending entity has no influence on business ownership and management.
Once the debt is fully paid, the business relationship ends.
Loan interest is tax deductible.
Loans are long-term or short-term.
It is easy to budget loan and interest figures as they are known.
Demerits of financing businessthrough debts
Regardless of business failure or closure, debt must be paid.
In the event of cash flow hitch and too much debt could lead to loan repayment troubles.
Too much debt is seen by potential investors as ‘high risk’ which limits future opportunities for business financing through equity.
In the event sales dips and business is faced with hard times, debt repayment could highly weaken the business.
In some cases, business growth is hindered by the cost of loan repayment.
The business assets are held as collateral by the loan lender.
However,based on the above assessment for business financing, it is ideal toblend debts and equity while seeking business activities expansionthis will balance the downsides of each. In this case, the rightratio will depend on the type of business, amount of money needed toexpand business, expected profits and cash flow.Selectingan investment banker to assist the business in raising this capital Inthe selection of investment bankers, business owners need to askthemselves two important questions how much finance they want andthe ideal investor. This information is vital in making decisions onwhat is needed by the business. In broader terms, business ownersneed to have clarity of investment banking process and make sure theinvestment banker understands the business segment. In addition, theinvestment banker should have solid relationship and experience withthe investors ensure that the banker’s motives match the businessowner’s. Lastly, the business owner needs to select a partner notjust an investment banker (Mishkin,2012).Risksand returns for stocks and bondsAcommon assumption among investors is that, the higher the risksinvolved in an investment the higher the returns. There existsubstantial differencein levels of risks associated with corporate bonds and common stocks(Tracey,2014).Ideally, corporate bonds have lower investment risks and thus offerlow returns, common stocks on the other hand, have higher investmentrisks and high potential returns. Theperformance and financial stability of the company issuing corporatebonds determines the return risks. Common stocks provide investorswith an opportunity to become shareholders and thereby entitled todividends depending on the shares held. Corporate bonds have lowerrisks and in the event the company is declared bankrupt, bond holdershave right to claim for payment unlike with common stocks (Grinblattet al. 1995).However, corporate bonds have low return on investment than commonstocks. Preferred stocks have low risks, high yields and investorshave better claim for payment if the company is declared bankrupt. Portfoliodiversification is a means through which investors eliminate andminimize exposures to systemic risks, company risks or short termeffects of assets class net performance. A well conceived portfoliois a well diversified portfolio in terms of returns. In the stockmarket, portfolio diversification could be used to diversifyinvestments on stock and bonds to reduce investment risks (Mishkin,2012).Similarly,investors can moderate individual asset performance value as a formof portfolio diversification. In this respect, investors need todiversify their portfolio investments by investing in broader marketinvesting across asset classes. This is important in minimizingsystematic risks and specific risks for instance one can blend fiveasset classes which are less correlated with those asset classes thathave expected returns of 12% at standard deviation of 10%. In thiscase the standard deviation of expected portfolio returns will beless than 10%, and expected returns will be 12% (Grinblattet al. 1995).In broader sense, if the assets have slight deviation or correlation,together, they would form an investment that is superior toindividual assets, thereby achieving great returns at minimal risks(Tracey,2014).
MarkGrinblatt, Sheridan Titman, Russ Wermers, 1995 ‘MomentumInvestment Strategies, Portfolio Performance, and Herding: A Study ofMutual Fund Behavior’.The American Economic Review, Vol. 85, No. 5 (Dec., 1995), pp.1088-1105
Mishkin,Frederic.2012, ‘TheEconomics of Money, Banking and Financial Markets’ (Global, TenthEdition).Pearson Education Limited. ISBN 978-0273765738.
TraceySandilands, 2014, ‘AreCorporate Bonds Riskier Than Common or Preferred Stock?’Demand Media, Internet resource,smallbusiness.chron.com/corporate-bonds-riskier-common-preferred-stock-38641.html