What Are the Advantages and Disadvantages for Amsc to Forgo Their Debt Financing and Take on Equity Financing?
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Equity and Debt
What are the advantages and disadvantages for AMSC to forgo their debt financing and take on equity financing?
If we see the financial statements of AMSC, it has been a debt free company and funded by equity capital. Therefore, the decision to stick to equity financing and forgo debt financing was in lines with the ongoing tradition of the company to utilize equity capital for financing operations. The major advantage of such a strategy is that it allows company to eliminate fixed interest payment burden on debt taken by the organization. In other words, the company would need not worry about paying interest payment and principal repayment on debt taken by the organization during tough times or periods of cash crunch and liquidity problems. In other words, the firm would appear very strong to prospective investors, creditors and lenders as it would essentially mean high security for their advances or money extended/invested in the firm.
However, the major disadvantage of pursuing this policy for a well established corporation like AMSC is that they are not able to utilize the leverage offered via debt financing. As the company is debt free, it can certainly take some debts in the books up to a fairly comfortable debt to equity ratio, say .25:1 or even .5: 1 and enjoy the leverage extended by the debt funding. By leveraging debt, the owners can earn a higher return for its shareholders as well as prevent dilution of equity that can occur due to fresh raising of capital via equity financing. In other words, an optimal amount of debt to equity ratio would allow the firm to take advantage of leverage offered via debt and increase returns for the shareholders.
However, AMSC was a loss making business in 2003, the decision to finance via equity was a prudent one as it could not afforded interest payment burden. I agree with their decision to take equity financing at that stage because the firm was growing at that stage and could not afford to bear the burden of huge interest expense. Hence, equity financing was a prudent decision to move ahead as it prevented further loss on account of interest expense. Further, the major disadvantage of debt financing at that point of time would have been increase in the risk levels of the organization, which would have been perceived negative by the markets as the firm was already in loss and could not afford more losses.
In todays scenario, AMSC can afford to take some debts in the books and enjoy the leverage offered by debt capital to increase returns to the shareholders of the organization.
Let us take a scenario that AMSC uses debt financing for funding its operations in 2003, when it was a loss making entity. Now, the company was already facing shortage of cash and additional burden of regular interest payment would have worsen the situation