17.6 Alternative Sources of Funds

Companies use various financing methods to fund operations and growth. Equity and debt are the main sources, with preferred shares offering a hybrid option. Each type impacts the company's cost of capital differently, affecting its overall financial structure and performance.

New equity issuance can increase costs and dilute ownership, while convertible debt offers flexibility. Alternative methods like private equity, venture capital, and crowdfunding provide unique benefits. Understanding these options helps firms make informed financing decisions to support their goals.

Equity and Debt Financing

Return required by preferred shareholders

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• Preferred shares offer investors a fixed dividend payment prioritized over common stock dividends
• Lack voting rights typically associated with common shares
• Required return on preferred shares calculated using the formula $r_p = \frac{D_p}{P_0}$
  • $r_p$ represents the required return on preferred shares
  • $D_p$ denotes the annual preferred dividend per share (e.g., $2 per share)
  • $P_0$ signifies the current market price per preferred share (e.g., $50 per share)

Calculation of WACC with preferred shares

• WACC reflects the blended cost of a company's various financing sources equity, debt, and preferred shares
• Each financing component weighted by its proportional contribution to the overall capital structure
• WACC formula incorporating preferred shares: $WACC = w_d r_d (1 - t) + w_e r_e + w_p r_p$
  • $w_d$, $w_e$, and $w_p$ represent the weights of debt, equity, and preferred shares, respectively (e.g., 40%, 50%, 10%)
  • $r_d$, $r_e$, and $r_p$ denote the costs of debt, equity, and preferred shares, respectively (e.g., 6%, 12%, 8%)
  • $t$ signifies the corporate tax rate (e.g., 25%)
• To include preferred shares in WACC calculation, determine their weight in the capital structure and required return

Equity Issuance and Convertible Debt

Impact of new equity on cost of capital

• Issuing new equity can potentially increase a company's cost of equity capital
• New equity dilutes existing shareholders' ownership stake and control
• May signal management's belief that the stock is currently overvalued
• Increased supply of shares in the market can exert downward pressure on the stock price (supply and demand)
• Lower stock price translates to a higher cost of equity capital due to their inverse relationship
• Companies must carefully assess the timing and necessity of new equity issuance to minimize negative impacts

Features of convertible debt funding

• Convertible debt combines characteristics of both debt and equity financing
• Issued as debt with a specified coupon rate and maturity date (e.g., 5% coupon, 5-year maturity)
• Grants bondholders the option to convert the debt into a predetermined number of common shares (e.g., 10 shares per bond)
• Benefits for the issuing company:
  1. Lower coupon rate compared to traditional debt due to the embedded conversion option
  2. Delayed dilution of ownership until bondholders exercise their conversion rights
  3. Attracts investors seeking potential equity upside while maintaining downside protection
• Benefits for investors:
  1. Opportunity to participate in the company's growth prospects through the conversion feature
  2. Fixed income payments and principal repayment if conversion is not exercised
  3. Downside protection in the event of company underperformance or bankruptcy

Alternative Financing Methods

Private Equity and Venture Capital

• Private equity firms invest in established companies, often through leveraged buyouts
• Venture capital firms provide funding to startups and early-stage companies with high growth potential
• Both offer expertise and guidance to help companies grow and increase value

Mezzanine Financing

• Hybrid form of financing that combines elements of debt and equity
• Typically used to finance expansion or acquisitions
• Offers higher returns than traditional debt but less dilution than equity

Crowdfunding and Angel Investors

• Crowdfunding platforms allow companies to raise small amounts from a large number of individuals
• Angel investors are wealthy individuals who provide capital to startups in exchange for equity or convertible debt
• Both methods can be particularly useful for early-stage companies or niche projects

Other Financing Options

• Factoring involves selling accounts receivable to a third party at a discount to improve cash flow
• Companies can also consider leasing equipment instead of purchasing to preserve capital