QUESTION: what are the advantages and disadvantages of each of the option (i)debtfinancing (ii) issuing common stock (iii) preference share

When considering debt financing a qualitative advantage can be that debt is not an ownership interest in the firm. As a result, creditors have no voting power or control in how a business is operating and entrepreneurs are able to make key strategic decisions. Another benefit is that it may be easy to administer as it generally lacks the complex reporting requirements that accompany some forms of equity financing. Additionally, having debt motivates the firm to improve operations so as to meet these financial obligations. On the other hand, using debt includes various qualitative disadvantages. Firstly, there exist a collateral requirement, thus creditors can legally claim the assets of the firm in the event of default. This can result in liquidation or reorganization of the company. Another aspect is that the company would have to deal with lenders and their criteria to obtain a loan. Moreover, covenants might be stipulated in the lending documents and could impose restrictions on the operations of the business. Another shortcoming is that too much debt may impair the firm’s credit ratings and their ability to raise money in the future. Lastly, the availability of debt financing is often limited to established businesses, since lenders primarily seek security for their funds. Thus, it can be difficult for unproven businesses to obtain financing.

A qualitative advantage of financing with equity in the form of common stock is that stock options can be used to motivate employees of all types. This would also promote the alignment of employee and shareholder interest. Another benefit is that business assets do not have to be pledged as collateral to obtain equity investments. Moreover, businesses with sufficient equity will look better to lenders, investors and the IRS. Conversely there exist qualitative disadvantages with this financial instrument. Firstly, stockholders are entitled to ownership interest and voting rights. Thus, there is a dilution of control allowing the possibility of takeovers by other companies and proxy fight by unhappy stockholders who act to replace existing management. Another drawback is that the utilization of equity markets to finance acquisition tends to be dependant on the market place. Thus if the industry turns down a company may suffer. Finally, the placement of equity in the form of common stock requires companies to meet many state and Federal regulatory requirements as directed by the Securities and Exchange Commission.

A third option of financing is that of preference shares. A qualitative advantage is that there is no dilution of management’s interest in corporate growth or in voting power (if non-voting preferred stock is issued). Also, in the event of sale of new equity, the company must first offer share to preferred stockholders to allow them to maintain their pro rata interest. This would limit the flexibility to bring in new shareholders who can influence the company’s operation systems. However, a disadvantage is that preferred stock always has the right to convert to common stock, thus creating voting power and dilution of control. Furthermore, a protective provision exists where a long list of items must be approved by 51-67% of preferred stockholders, including: sale, merger or liquidation of company; sale of shares with more privileges; issuance of debt over dollar amount; increase in board size and such like. Thus, this puts preferred stockholders in a position to manage affairs of the company and decide when the company is sold.