In order for a company to keep expanding it is vitally important for them to raise capital especially in the ever changing competitive business environment. There are two main ways of raising capital for a company and they are either debt or equity. However, it is possible to have a combination of the both in some circumstances.
Equity is where companies issue shares through a number of ways such as ordinary shares, preference shares or deferred ordinary shares. This is a way of attracting shareholders in a goal to get them to invest. Shareholders in turn will consider the rate of return that the company is offering compared to other investments with an equal amount of risk. One advantage of using equity as a source of capital is that the company are not required to pay back the full amount invested or pay back dividends. On the other hand, shareholder activism could result in a loss of shareholders if the return is not satisfactory to the shareholders. Even though the company are under no obligation to return the payment through dividends, in order to satisfy the shareholders it is necessary to compensate them with the satisfactory return.
The Dividend Policy must be considered if equity is being used as a means of raising capital. As discussed in a previous blog, shareholder wealth will be maximised if profits are treated in a certain way to benefit the shareholder, which can only be an advantage to the company. Miller and Modigilani (1958), state that companies must take into account what they issue in the form of dividend which may impact their share price on the stock market, and even more so the impact this change in share price may have on future investors. The Clientele Effect is a result of this because where the share price of a company can move in reaction to a change in policy, in this instance it would be a dividend change, and therefore the use of raising capital through Equity would require constant examination of the company, in relation to shareholder wealth maximisation.
The cost of satisfying these shareholders can be high and can result in a business losing control however maximising shareholder wealth and gaining shareholder funds is a good way to enhance profit and the business, which links to the agency theory problem and managerialism. However, holding managers accountable for their actions can only benefit a company, for example BP have been recently held accountable to their shareholders, through the legal system, due to two oil spillages that occurred in 2006. The voice of the shareholders here is vital to hold the necessary people responsible for their actions that have impacted not only the company and its stakeholders but many others, increasing a company’s awareness of its corporate social responsibility.
Another way to raise capital is by the use debt. In this case lenders have no official control over the business and are unable to vote at meetings which mean they cannot choose the directors or make major strategic decisions. Usually companies cannot last on the stock market at such an early stage in their life but with the funding of debt they can benefit greatly on the stock exchange. Debt has a much lower cost than equity, but still requires repayments to the investor, with interest included as part of the repayment, and these repayments will be required regardless of how the business has performed during the year. Businesses can also use their secured assets to finance their debt, which can cause complications if the business were unable to sustain the repayments on their loans and may even result in losing the business entirely.
Both equity and debt have their advantages and disadvantages in relation to raising capital, however if a business were to use a mixture of both they would not only benefit from increased business exposure and accountability, but will also be able to use finance and repay it without having to worry about a lifelong connection to their investor.
Miller, M. H. & Modigliani, F. (1958). Dividend policy, growth, and the valuation of shares. The Journal Of Business, 34 (4), pp. 411--433.
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