Factors Influencing Companies in Choosing Between Securing Funds Through Stocks or Bonds

Deciding whether to raise funds through issuing stocks or bonds is a critical decision for companies, often dictated by their nature of business, market conditions, and internal capital structure. This decision heavily influences a company's financial health and long-term sustainability. While some companies may opt for equities to avoid sending negative signals, the choice ultimately lies in a complex interplay of financial and operational factors.

Why Issuing Stocks Sends a Negative Signal

For firms that can afford bonds, issuing equity tends to send a negative signal. Banks, due to their diversified capital structure, can issue both stocks and bonds without significantly altering their capital ratios. However, for growth firms, the decision to issue equity is more nuanced. Issuing conventional bonds increases the company's debt, adding more risk to the balance sheet. Some growth firms mitigate this risk by issuing convertible bonds. These bonds offer equity guarantees, essentially turning into shares if certain conditions are met. This approach helps them keep the capital structure relatively stable while also securing necessary funds.

Business Cycle and Capital Structure Considerations

Decisions to issue stocks or bonds are highly dependent on the nature of the business and market scenarios. Companies engaged in long-term sectors such as real estate, infrastructure, and construction, often find that issuing stocks is more suitable. In these sectors, projects are capital-intensive, with large initial outlays and long payback periods. The order books may have limited high-value orders, making debt financing more challenging. Issuing stocks allows these firms to maintain a lower debt-to-equity ratio, which is crucial for long-term stability and resilience.

During recessions, indebted companies face increased difficulties in securing additional capital. The lack of liquidity and lower credit ratings often push them towards equity financing. Conversely, in bull markets, the potential for higher returns on investments can make debt financing more attractive. For instance, if a company's business return is 25% per annum, and it can secure debt at an interest rate of 12%, the return on equity will appreciably increase. This makes equities more appealing, as the higher returns compensate for the risk of debt.

Capital Structure and Investment Costs

Every company maintains a capital structure that it adheres to, a mix of debt and equity that reflects its risk tolerance and financing goals. For example, Hindustan Unilever Limited (HUL) on the National Stock Exchange (NSE) has a capital structure almost entirely composed of equity, with negligible debt. This reflects a low-risk, steady growth strategy.

Companies raise capital primarily to fund new projects, such as building manufacturing units or acquiring other businesses within the same industry. Each form of capital raises costs attached to it. Debt incurs interest payments, while equity costs are underpinned by dividends, bonuses, and possible share repurchases. Together, these costs form the Weighted Average Cost of Capital (WACC).

A company makes rational and efficient use of capital by ensuring that the return from any investment or project surpasses its WACC. This principle is analogous to the decision-making process when buying a car; a sensible person wouldn't buy a vehicle with monthly instalments exceeding their monthly earnings. Similarly, companies carefully evaluate the cost and returns of various financing options, aiming to minimize costs while maximizing returns.

Key Takeaways and Further Reading

Understanding the factors influencing a company's choice between issuing stocks or bonds is crucial for investors, managers, and financiers. The decision is influenced by the company's capital structure, business cycle, market conditions, and internal financial goals. Companies with long-term, capital-intensive projects often prefer stocks to maintain their balance sheets.

To learn more about corporate finance and these concepts, consider reading the book Financial Intelligence (Amazon affiliate link). This book provides a comprehensive understanding of corporate finance, including detailed explanations of WACC and other financial metrics.