FIN 301 Case 5-American Superconductor
Introduction
American Superconductor Corporation is a world leader in the development of solutions and manufacture of products using superconductor wires and power electronic converters for electric power generation and distribution. American Superconductor Corporation’s products and solutions improve its client’s efficiency, costs and reliability of systems that are utilized in electric power infrastructure. The company was founded in 1987 and its registered office and headquarters are based in Westborough, Massachusetts in the United States of America (PR Newswire, 2003; Esposito, 2003). The Corporation’s products and solutions including those sold by its business associates using its solutions and products are known to conserve resources used in electric power production, dramatically increase reliability and bandwidth of power delivery grids and reduce clients manufacturing and operating costs (http://www.amsuper.com). The company has made patent applications and obtained licenses covering technologies instrumental to revolutionizing electricity usage in the world and has patented more than 500 vertically integrated portfolios of products in this regard. American Superconductor’s main products include advanced power electronic systems that guarantee reliability and quality of electricity for residential, commercial and industrial customers, HTS motors and generators for ship propulsion, High Temperature superconductor wires for electric power infrastructure and industrial and medical processing applications solutions and products (www.amsuper.com; Esposito, 2003).
Analysis of debt versus equity financing
In the financial year 2003, the then American Superconductor Corporation’s chief executive officer, Gregory J. Yurek, announced that the company under the then prevailing market conditions had decided to forego its earlier decision to finance its future business operations using secured debt and was instead going to use equity financing. The secured debt financing package was to be made up of a $ 10 million credit facility extended by the firm’s bankers, subordinated notes of $ 10 million and financing from three institutional investors totaling $ 30 million (Esposito, 2003). This decision by the company to either use debt or equity financing to finance future business operations was an important decision that must have been made after careful analysis of the risks involved (Chiang & Hanke, 2010). Debt financing involves payment of scheduled installments to the lenders as per agreed lending terms. Debt financing in most cases involves creation of a security interest over a company’s specific asset portfolio which may limit their future use during the tenure of the debt instruments. In the case of American Superconductor Corporation; had the firm chosen debt financing, one of the lending terms and conditions could have been creation of a legal charge over several prime assets such as prime land which may have included the land on which it operated on(Young, 2007). This would have meant that the company could not charge the land to any other lender without knowledge and permission of the secured creditors to secure additional financing (Esposito, 2003).
Another important condition would have been that the secured debt providers would have insisted on taking a floating and fixed debenture over the company’s assets. This would have given the lenders a number of advantages which include the right to put the company into receivership should the need arise in future and also a security interest over any other assets that the company may acquire in future during the term of the loan. Under the provision of a debenture agreement over the company assets, should the secured lenders in future feel that their interests in the company are at risk they could put the company into receivership (Esposito, 2003). This involves essentially taking over the company and appointing their own managers to run it. This puts the current owners at risk of losing their equity stake in the company. Debt financing reduces the amount of money that is distributable to stockholders at the end of the financial year as dividends (Chiang & Hanke, 2010). This is because interest expense is included in the financing costs of the company which is expensed in the statement of comprehensive income at the end of the financial year. This treatment of financing costs reduces the amount recorded as earnings after taxes, interest and depreciation & amortization. This earnings figure is the one that is transported to the cash flow statement and is used to calculate free cash flows from which dividends are paid to shareholders (Young, 2007). It therefore follows that attaining optimum debt financing is undesirable for stock holders. Another major disadvantage of debt financing is that the company must make scheduled payments which puts pressure on the cash flows. Debt financing however, has tax benefits in that revenue authorities calculate tax payable by a company after deducting financing costs which include interest expense on running loans. Firms that attain optimal debt financing are able to pay reduced taxes than those that rely on equity financing (Chiang & Hanke, 2010).
According to Fosberg (2004) the decision whether to rely on debt financing or equity financing in a company is at times influenced by agency problem. Agency problem refers to the separation of control between management and shareholders. This is because in a company where managers are shareholders or are allowed stock options as one of the incentives, the decision to use optimal debt financing is compromised. This is because managers just like shareholders would make decisions that enhance/increase their dividend payout at the end of the year. Manager ownership stake in the company motivate them to pursue wealth maximization in this case. Manager ownership inhibits the ability of the company to make risky but lucrative decisions which could enhance the returns of the company remarkably (Young, 2007). As shareholders, managers become risk averse and as such only make investment decisions that prevent bankruptcy of the company. This however makes the company uncompetitive as it increasingly makes risk averse and conservative investment decisions. The company in this case risk losing business to more aggressive risk taking competitors (PR Newswire, 2002). Eventually as the company continues to lose business and its future viability become increasingly uncertain managers opt to sell off their shares and opt out before the sheep sinks which compromises the position of the main shareholders. Equity financing has been known to be costly in the long term as the founder members lose control of the business over time. Equity financing involves ceding control of the businesses to the new financiers (Boudreaux, Rao, Underwood & Rumore, 2011). This therefore implies that the original shareholders will not be in a position to make decisions affecting the strategic direction of the company solely. This poses the risk of losing the original vision and inspiration that informed the formation of the company. Equity financing cannot be pursued indefinitely and is only ideal when business future is uncertain as was the case in American Superconductor Company. When a business environment is uncertain a company can rely on equity financing to ease pressure on cash flows. This is because unlike debt financing which requires scheduled loan repayments equity financing does not and the only time the company pays equity financiers is at the end of the financial year when dividends declared are paid out (Young, 2007).
In order to determine a firm’s cost of equity we use the capital pricing model (CAPM) equation follows;
Kc = Rf + beta x (Km – Rf)
Where
Kc is the risk-adjusted discount rate (also known as the Cost of Capital);
Rf is the rate of a “risk-free” investment, i.e. cash;
Km is the return rate of a market benchmark, like the S&P 500
Once we determine the risk free rate which is normally the government bond rate and the market rate which is normally the market benchmark like S&P500 and the company’s beta coefficient we can calculate the cost of equity which is the risk adjusted rate (CAPM Calculator retrieved from http://www.moneychimp.com/articles/valuation/capm.htm)
References
American superconductor announces plan for common stock offering. (2003, Aug 25). PR
Newswire. Retrieved from http://search.proquest.com/docview/451870365?accountid=45049
American superconductor announces restructuring, consolidation and cost-cutting measures. (2002, Mar 26). PR Newswire. Retrieved from http://search.proquest.com/docview/449096691?accountid=45049
Boudreaux, D. O., Rao, S., Underwood, J., & Rumore, N. (2011). A new and better way to
measure the cost of equity capital for small closely held firms. Journal of Business & Economics Research, 9(1), 91-98. Retrieved from http://search.proquest.com/docview/848788678?accountid=45049
Chiang, W., Di, H., & Hanke, S. A. (2010). Debt or equity financing? analyzing relevant factors. The Tax Adviser, 41(6), 412-417. Retrieved from http://search.proquest.com/docview/521247918?accountid=45049
Esposito, A. (2003, Aug 26). American superconductor switch ; westboro company plans to raise money through a stock offering. Telegram & Gazette. Retrieved from http://search.proquest.com/docview/268865037?accountid=45049
Fosberg, R. H. (2004). Agency problems and debt financing: Leadership structure effects. Corporate Governance, 4(1), 31-31+. Retrieved from http://search.proquest.com/docview/205137312?accountid=45049
http://www.amsuper.com
http://www.moneychimp.com/articles/valuation/capm.htm
Young, V. M. (2007). DEBT, EQUITY FINANCING QUESTION BECOMING MORE DIFFICULT. WWD, 194(59), 20. Retrieved from http://search.proquest.com/docview/231195416?accountid=45049
Last Completed Projects
| topic title | academic level | Writer | delivered |
|---|
Are you looking for a similar paper or any other quality academic essay? Then look no further. Our research paper writing service is what you require. Our team of experienced writers is on standby to deliver to you an original paper as per your specified instructions with zero plagiarism guaranteed. This is the perfect way you can prepare your own unique academic paper and score the grades you deserve.
Use the order calculator below and get started! Contact our live support team for any assistance or inquiry.
[order_calculator]