Debt of Capital: Debt or Equity
Debt signaling is a sign provided to investors and other stakeholders of the company that the company is going to issue debt financing or delay the issuance of this form of financing. If a company management decides to issue debt financing, it gives out a positive signal. A company that is in a stable financial position would be willing to issue debt. As interest has to be paid on debt, a company that has a stable financial basis would opt for this method of raising finance. On the other hand, if the company delays the issuance of debt financing it gives out negative signals. This delay in issuance shows the company has an unstable financial position, and would discourage investors from investing in this company; likewise, existing investors may want to sell their securities. Equity financing allows for a company to give out signals that the company is offering ownership in the company (Fama & French, 1997). By buying the stocks of a company an individual buys ownership in the company. They may not receive immediate returns and need to understand that business growth takes time. However, this is a risky decision as the shareholder may lose all or part of his investment if the business does not work out. Venture capitalists and angel investors are some of the examples of people who may be interested in equity financing (Jiang & Koller, 2011).
The pecking order theory which is also known as the pecking order model states that the cost of financing increases when there is no balance in the information available. The company management decides on their financing needs from three sources that include; internal financing, debt financing, or equity financing. Most companies would give the highest preference to internal sources of financing because of the low cost associated with this option. Debt financing is the second best option available, and equity financing is the last resort for most companies. However, these may differ company to company and the varying strategies they all have. According to the theory, a pecking order exists for new projects because of the information that is available to managers and affects their decision making (Frank & Goyal, 2007). As mentioned earlier, debt financing or equity financing would be largely determined by the asymmetrical information that is available to managers. Based on this information, they would prefer debt financing over equity financing. Debt financing points out that the company’s stock price is under-valued and had it been over-valued the company would have issued equity. This theory does not take into account the varying managerial perspectives and selections of debt and equity financing. The decision to issue debt or equity is largely determined by external factors and the management’s own preference.
Preferred stocks or preferred shares comprise the company’s equity finance along with common shares. They are given preference over common shares, but they rank below bonds in terms of claims over the company’s assets. Preferred stock has traits that are a combination of equity financing and debt financing because of which it is also known as a hybrid instrument. As the preferred stockholders are guaranteed a fixed dividend rate, it is relatively simple to calculate the cost of raising this finance. The preferred stock dividend is divided by the preferred stock price and added to the growth rate. Three companies that are trading in the stock exchange and have preferred stocks in their equity include; HSBC, JP Morgan, and Merill Lynch. All the three mentioned companies are related to the financial sector. HSBC provides banking services, JP Morgan is a financial institution, and Merill Lynch offers financial advisory services across the US.
Fama, E. F., & French, K. R. (1997, May 1). Taxes, Financing Decisions, and Firm Value. by Eugene F. Fama, Kenneth R. French. Retrieved March 31, 2014, from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1871
Frank, M. Z., & Goyal, V. K. (2007, December 8). Trade-Off and Pecking Order Theories of Debt. by Murray Z. Frank, Vidhan K. Goyal. Retrieved March 31, 2014, from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=670543
Jiang, B., & Koller, T. (2011, May 1). Insights & Publications. Paying back your shareholders. Retrieved March 31, 2014, from http://www.mckinsey.com/insights/corporate_finance/paying_back_your_shareholders