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For long term funding companies should always favour equity as a source of finance
According McLaney and Atrill (2020) with equity financing, via the sale of ordinary shares, there is no obligation for an organisation to make interest payments and capital repayments thereby not putting the business in financial jeopardy. However, the disadvantages to equity financing is that the sale of shares means that you are now sharing ownership and profits. This could lead to differences in the way the business should be run, the vision and overall culture of the company could be impacted.
Cremades (2018) stated that the biggest advantage of financing via debt as opposed to equity is the fact that you retain full control and ownership: once the debt is paid up then your liability is over. The cost of capital is also reduced once the business considers the tax deductions that is created due to debt financing. The downside to debt financing is that irrespective of business performance, periodic payments must be made. “Too much debt can negatively impact profitability and valuation. Meaning, it can lead to inferior equity raising terms in the future” (Cremades, 2018).
There is no hard and fast rule in deciding a source of funding. The business must consider the ideal mix between debt and equity. “The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company’s market value while minimizing its cost of capital” (Hayes, 2019). The return on capital must be greater than the cost of capital for an investment to be worthwhile. “The trade-off theory of capital structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits” (Lumenlearning, 2009). Using this theory in practice provides an organisation the ability to decide on how much debt finance and how much equity finance to use by balancing the costs of debt against the benefits of debt.
Retained profit as a source of finance has few if any drawbacks
Retained profits is a businesses’ own money. As a source of finance, it is economical, convenient and it does not have to be paid back. However, McLaney and Atrill (2020) stated that retained profits does come at a cost to a company if used as a source of funding due to the opportunity cost to shareholders. “If shareholders receive a dividend, they can use the cash to make other income-yielding investments. If the business retains the cash, shareholders are deprived of this potential income” (McLaney and Atrill, 2020). Whilst building up retained profits to a sizable amount for reinvestment into the business, there could be several missed opportunities. Utilising retained profits for business ventures will result in low dividends and ultimately dissatisfied investors who might take their investments elsewhere. This sell-off could lead to a negative impact on share prices and if share prices drop sharp enough, the business could become susceptible to a takeover.
References
Atrill, P. (2017) Financial Management for Decision Makers. Pearson Education M.U.A.
Chand, S. (2014) Retained Profits or Ploughing of Profits: it’s Advantage and Disadvantage. Your Article Library. Available online: https://www.yourarticlelibrary.com/financial-management/retained-profits-or-ploughing-of-profits-its-advantage-and-disadvantage/27975 [Accessed 17 Jun. 2020].
Cremades, A. (2018) Debt vs. Equity Financing: Pros And Cons For Entrepreneurs. Forbes. Available online: https://www.forbes.com/sites/alejandrocremades/2018/08/19/debt-vs-equity-financinpros-and-cons-for-entrepreneurs/#75c476a36900 [Accessed 17 Jun. 2020].
Hayes, A. (2019) Understanding Optimal Capital Structure. Investopedia. Available online: https://www.investopedia.com/terms/o/optimal-capital-structure.asp [Accessed 6 Jun. 2020].
Lumenlearning (2009) Capital Structure Considerations | Boundless Finance. Lumenlearning.com. Available online: https://courses.lumenlearning.com/boundless-finance/chapter/capital-structure-considerations/ [Accessed 16 Jun. 2020].
McLaney, E. and Atrill, P. (2020) Accounting and Finance: An Introduction. 10th ed. Harlow: Pearson
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