WHY SEEK FINANCIAL AID?
Businesses, both small and medium scale enterprises along with large conglomerates at one point or the other will seek some financial assistance. For various reasons, such as expansion, Mergers, Investment opportunities, etc.
In countries where there is a healthy gross domestic product (GDP) and high consumer spending. There will always be a need for some financial aid, as people and businesses will seek capital or long-term borrowings to fund their projects.
The lifespan and scope of a project will definitely be an important determinant in seeking for funds. Projects with larger scopes, maybe on a global level, will require large pool of funds. This most times will not be funded solely by the company’s retained earnings as it might not be sufficient. This brings in the two classical options of Equity funding and Debt funding.
EQUITY AND DEBT FUNDING
This are funds gotten from individuals who trade their cash for shares in the company. They might or might not be directly involved in the day to day running of the business. They include; ordinary shareholders, preference shareholders, quasi shareholders, dormant shareholders, and so on.
Owners of such companies tend to take more caution in placement of shares for public and private subscription. So as not to dilute their controlling power over the entity.
This are borrowings made from the bank, in order to fund the business. It however comes with a finance cost, which the bank charges as interest on the loan.
In theory, it is believed that debt financing is cheaper than equity financing. These are because of a few reasons which includes;
- Interest on loans is tax deductible: A company which is ungeared (i.e., has no long-term borrowings) that makes a similar amount of profit with a geared company (i.e., has long-term borrowings in its capital structure) will end up paying more in tax.
Tax rules in most jurisdictions allow the interest paid on loans to be deducted from profits, before tax is deducted. Hereby, reducing the total amount of tax to be paid.
- In the event of an insolvency, the shareholders are settled last as a matter of preference. Debt holders get settled first, as these agreements will in most cases hold some covenants tied to the contract.
There have however, being some arguments, that debt is not a cheaper source of finance. Modigliani and miller, first argued that the savings gotten from debt financing will be cancelled out when we consider that equity holders will demand more return as a result of the additional risk that comes with debt finance that the business is venturing into.
This increase in required return by shareholders, will in effect, cancel out the savings on tax gotten from the long-term borrowings.
Businesses, both SMEs and large corporates will at some points, have need for financing, either to recoup more cash for the day to day running of the business or for the achievement of the strategic goal of the company.
Care will need to be taken on which source of financing will be better for the long-term success of the business.