The Capital Asset Pricing Model (CAPM)
CAPM is a financial formula used to compute the anticipated return on an investment. The formula considers three variables. These are the Risk Free Rate, Expected Market Return and the Asset Beta. The Asset Beta is a proxy for the variability in the investment’s returns. The CAPM formula is:
Ra= rf +ßa (rm-rf)
The return on the asset is obtained by adding the risk premium to the risk free rate. The risk premium is obtained by deducting the risk free rate from the expected market returns then multiplying the result by the asset beta.
Investors use CAPM to determine the minimum return they can accept on an investment. The message conveyed by this formula is that they should demand returns for taking the risk associated with the investment. The second part of the formula reflects this message.
The first part on the other hand portrays the basic return demanded for holding investors money. This risk free rate depends on the amount of money and the length of time the investment will retain this money.
CAPM shows corporations how investors determine the return demanded on their investment. Usually, return is expressed in terms of interest rate. CAPM also explains to corporations why they may receive higher or lower interest rates than their counterparts. This is so because a company with a higher beta will obviously be charged a higher interest rate than one with a lower beta.
Therefore, corporations that know their beta can estimate their projected cost of capital for the investment in question. Corporations are also able to work on the factors that increase their beta. Reducing their beta in effect reduces their cost of capital.
Advantages of AMSC’s Equity Financing vs. Debt Financing
Equity financing involves calling on investors to provide the required capital by purchasing shares. The advantage of this is that the corporation avoids the obligation to repay the money. Shareholders will expect returns in terms of dividends rather than loan repayment. Unlike debt financing where regular repayments have to be made, no repayment is made in equity financing.
This is important in cases where the company is experiencing or expecting problems with their cash flow. The additional burden of debt repayment can destroy a company with cash-flow difficulty. In such cases, equity financing is best.
Equity financing has no impact on the company’s credit rating. When a company uses debt financing and delays or fails to repay, their credit rating is reduced. This lowers their chances of obtaining another loan and increases the subsequent interest rates. In addition, equity financing eliminates the cost of interest. It also eliminates any penalty due on default.
Equity financing can also come with valuable investors. Such investors provide value chain advantages since they are interested in the prosperity of the business. They can also provide valuable advice due to their experience.
Such advantages are not available in debt financing. Lenders’ only interest is getting back their principle and interest. They have no interest in the operating excellence of their borrowers.
Lastly, equity financing unlike debt financing does not increase the leverage of a company. Increased levels of debt correspond to increased levels of leverage. This means greater risk of corporate failure due to inability to meet debt obligations to investors. Generally, equity financing is safer in poor economic conditions.
In view of this, I agree with the management at AMSC to forego the debt and use equity instead. The company’s business is currently growing. This means additional working capital needs. Debt financing repayments may strain the company.
The Navy and government projects also require funds. Given the slow public procurement methods, the payment may be delayed for a while. Shareholders can wait for these future benefits; debt financiers cannot (Esposito 3).
Estimating Cost of Equity
The return demanded by shareholders is referred to as the cost of equity. One can determine the cost of equity using either CAPM or the dividend growth model. The CAPM model has been discussed above. It incorporates the Risk Free Rate, Expected Market Return and the Asset Beta.
The Dividend Growth Model formula is as follows:
Cost of Equity = (Dividend for next year/Current Stock Price) + Dividend Growth Rate
This model assumes that a company’s annual dividend is not constant; rather it grows steadily from year to year at a known rate (Weetman 61).
Debt Tax Shield
It is true that debt financing has tax advantages. This advantage can be viewed from two different perspectives. First, debt reduces the taxable income through interest, which is tax allowable. The effect is that the firm in question pays less tax than if they were not using debt. Equity financing does not have this effect because unlike interest, dividends are not tax deductible.
Secondly, the saved tax theoretically decreases the interest rate on debt. This can be obtained using the formula: Theoretical Interest= (1 – tax)* Interest charged. These effects are referred to as Tax Shield. By choosing to forego debt financing, AMSC is foregoing the tax shield too.
Esposito, Andy. “American Superconductor switch ; Westboro Company Plans to Raise Money Through a Stock Offering.” Telegram&Gazette 23 Aug.2003: 1-3.Print.
Weetman, Pauline. Financial and Management Accounting: An Introduction. Chicago: Prentice Hall, 2007,Print.