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Choices in Raising Capital
Sell Equity or Issue Debt?
When a corporation needs operating capital to keep its business running, it typically has some flexibility in raising cash. That’s because the company can tap its current investors or attract new ones either by selling stock or issuing bonds. In fact, many corporations do both, though generally not at the same time.
If the corporation chooses what’s called a secondary stock offering, its board votes to issue more shares, thereby increasing the number available for trading. The advantage of this stock offering, from the company’s perspective, is that the money raised by the sale goes directly to the company, just as if it were an initial public offering. Since the company is already publicly traded and shareholders have had the right to vote on the board of directors and certain corporate issues, selling additional shares generally has very little impact on how the company is run.
But there are potential drawbacks to exchanging equity for operating cash. Increasing the number of shares in the market tends to lower the price of each share, since the supply has grown but demand may not have. Issuing additional shares also reduces the value of existing shareholders’ stake in the company — something they don’t like. To make the pill a little easier to swallow, corporations may use a rights offering, also called a subscription right, which gives existing shareholders the opportunity to buy additional shares in proportion to the number they already own before new shares are offered to the public.
Issuing Bonds: Immediate Cash for Debt With Interest
Rather than exchanging equity for a one-time cash infusion and risk diluting the market value of its existing stock, a corporation may prefer to borrow money from investors by issuing a bond or series of bonds. Unlike the cash raised by a sale of stock, the bond is a debt that must be repaid with interest. The interest is a tax-deductible business expense, however. This reduces the cost of borrowing, just as deducting your mortgage interest reduces the cost of borrowing to buy your home.
The interest rate the corporation pays on the bond will depend in part on the credit quality of its bond and its own creditworthiness as determined by a ratings agency. If the agency believes the company and bond pose a relatively low credit risk, the company can probably attract investors by offering an interest rate at the low end of prevailing market rates. If, on the other hand, the company’s financial position is shakier and its bond poses a relatively high credit risk, the firm may need to offer a higher interest rate to sell the bond. This possibly would strain the company’s cash flow.
One decision the business faces in issuing debt is how long the bond’s term should be. The appeal of a long-term obligation — say, 30 years — is that it provides an immediate cash infusion but gives the company a long time to repay. Among other advantages, inflation works in the company’s favor, since the capital it repays is likely to be worth substantially less than the value at the time it was borrowed. A downside, though, is that the rate required to float long-term bonds is typically higher than the rate for short-term ones.
To borrow at lower rates, corporations with good credit often prefer a rolling series of short-term bonds, known as commercial paper, which provide a steady stream of operating cash.
Tough Cash in Tough Economies
If the economy is in a recession and chances for a quick recovery are slim, the prospects for raising capital by issuing stock or bonds may be somewhat grimmer. If stocks are trading below their intrinsic value, a secondary offering of shares may not raise as much capital as the corporation wants. That, on top of saturating the market with shares, may create more problems than the offering solves.
Similarly, if a corporation has more debt than potential investors are comfortable with, a bond issue may not float. Or the issuer may have to increase the rate it has offered on earlier bonds to attract investor interest. In that case, repayment may become a substantial burden.
Virginia B. Morris is the Editorial Director for Lightbulb Press.