In business circles, there is the common saying that ‘Capital is King”. No matter how viable or profitable your business idea or enterprise may be on paper, your prospects are at best, limited without access to a stream of capital sufficient to midwife your idea or concept into reality. Capital is to a business what blood is to the human body and the interruption of its flow implies the cessation of the business or project within a relatively short period and a perennial complaint of business people is inadequate access to capital, high interest rates, and other factors affecting capital issuance.
When discussing the ‘printing press’ financiers refer to the practice of a Central bank issuing debt securities for the purpose of financing the activities of a company. In corporate circles however, the printing press refers to the issuance of debt securities by a company for the purpose of financing, irrespective of the intrinsic value of the organization.
Companies prioritize their sources of financing, first preferring internal financing, and then debt, lastly raising equity as a “last resort”. Hence; internal financing is used first; when that is depleted, then debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. Thus, the form of debt a firm chooses can act as a signal of its need for external finance. Companies have an advantage in using debt rather than using internal capital, as they can benefit from debt tax shields. This tax shield allows firms to pay lower tax than they should, when using debt capital instead of using only their own capital. The theory argues that the more debt is issued by the company, the more a firm’s value is created.
Asymmetric information (the availability of an informational advantage in favour of a party to a transaction) favours the issue of debt over equity as the issue of debt signals the boards confidence that an investment is profitable and that the current stock price is undervalued (were stock price over-valued, the issue of equity would be favoured). The issue of equity would signal a lack of confidence in the future prospects of the company by the board of Directors and that they feel the share price is over-valued and the Company can make more profit from the sales of equity than they would receive from the issue of debt. An issue of equity would therefore lead to a drop in share price.
The savvy CEO who desires to raise financing for his company without encountering the negative effects of equity issuance may ‘print’ cash by issuing debt securities for the purpose of obtaining capital for the prosecution of the projects and activities of the company. However, the value of the debt security thus issued depends upon a substantial number of variables, including the current and projected revenues of the company, micro and macroeconomic factors, and publicly available information relating to the company.
Research has focused on the empirical claim that companies face a sharply increased risk of default once their debts exceed certain percentages of revenue, usually 90% of annual revenues. In order for Debt security issues to be viable sources of corporate finance the projected revenues from the investment need to exceed the costs of issuing and servicing the debt. Unfortunately some companies make the error of raising debt to finance deficits in revenue,
The use of Debt securities as a mode of corporate finance implies undertaking the risk for the following occurrences;
- Costs of Capital: This refers to the effective rate that the company pays on its current debt and includes interest payable on the principal debt sum, costs of obtaining the funds and the opportunity costs of the proportion of revenue applied towards servicing the debt.
- Insolvency Costs: This includes bankruptcy costs, professional fees for insolvency practitioners and loss of goodwill arising from the insolvency process.
- Loss of Capital Market Access: In the event that the company defaults in the repayment of the principal or interest of the debt, the company may be restricted or limited from further accessing the capital market. Furthermore, the company may become a pariah in the financial markets, increasing the costs of acquiring further financing.
Milton & Cross provides investment advisory and due diligence services to individual and corporate investors who require legal advice prior to investment in corporate debt securities. We may be contacted directly on +2348036258312, or by email on: email@example.com