When companies need to raise capital, they have two primary options:
Debt involves borrowing money, while equity involves issuing shares of ownership in the company. Both options have advantages and disadvantages, and companies must carefully consider their financial situation and goals before making a decision.
Let's take a look at examples of companies that raised capital through debt, and analyze the factors that influenced their decision.
1) Apple: In 2013, Apple issued a $17 billion bond to return cash to shareholders and avoid repatriating overseas profits and incurring taxes. Apple had a strong credit rating and could borrow at a lower interest rate than the expected return on equity. Apple's weighted average cost of capital (WACC) at the time was around 7.5%.
Apple's credit rating was AA+ from S&P and Aa1 from Moody's, which allowed it to borrow at a low interest rate. The 10-year US Treasury yield in April 2013 was around 1.7%. Apple's bond issue included a 3-year bond at 0.45%, a 5-year bond at 1.00%, a 10-year bond at 2.4%, and a 30-year bond at 3.85%. The expected return on equity for Apple was around 12%, based on its historical performance and growth prospects.
By issuing debt at a lower interest rate, Apple reduced its overall cost of capital and increased profitability. The company was also able to avoid repatriating overseas profits and incurring taxes, which could have reduced its cash flow and earnings.
If Apple had chosen to raise equity instead of debt, it would have diluted the ownership stake of existing shareholders and reduced the earnings per share.
2) Ford: Ford: In 2020, Ford raised $8 billion in debt to boost its liquidity and support its restructuring efforts. The company was facing declining sales and increasing competition in the automotive market, which led to a credit rating downgrade and higher borrowing costs. Ford's WACC at the time was around 9.7%. Ford's credit rating was BBB- from S&P and Baa3 from Moody's, which was just above the threshold for investment-grade status. The 10-year US Treasury yield in March 2020 was around 0.7%, but Ford's borrowing costs were higher due to its credit rating downgrade and higher perceived risk.
If Ford had chosen to raise equity instead of debt, it may have been more difficult due to its credit rating downgrade and lower stock price.
3) Amazon: In 2020, Amazon raised $10 billion in debt to fund growth initiatives and potential acquisitions. The company had a strong credit rating and could borrow at a lower interest rate than the expected return on equity. Amazon's WACC at the time was around 7.4%. Amazon's credit rating was AA from S&P and A1 from Moody's, which allowed it to borrow at a low interest rate. The 10-year US Treasury yield in August 2020 was around 0.7%. Amazon's bond issue included a 3-year bond at 0.4%, a 5-year bond at 0.8%, a 10-year bond at 1.45%, and a 30-year bond at 2.2%.
On the other hand if Amazon had chosen to raise equity instead of debt, it would have diluted the ownership stake of existing shareholders and reduced the earnings per share.
To illustrate, assume Amazon raised $10 billion by issuing new shares at a price of $3,000 per share. This would result in the issuance of approximately 3.33 million new shares, diluting the ownership stake of existing shareholders by around 0.65%.
Assuming a net income of $21.33 billion in 2020 and 500 million outstanding shares, Amazon's earnings per share would be $42.66. If the company issued new shares and diluted the ownership stake by 0.65%, the earnings per share would decrease to $42.39. This represents a 0.63% reduction in earnings per share, which could negatively impact shareholder value.
In each of these examples, the company's decision to raise debt or equity was influenced by a combination of factors such as their credit rating, growth prospects, liquidity needs, and market conditions.
Debt can offer a lower cost of capital, tax advantages, and a predictable repayment schedule, but it also increases the company's leverage and interest expenses.
Equity can provide financial flexibility, align the interests of the company and its investors, and offer a cushion against financial distress, but it also dilutes ownership and reduces earnings per share.
The decision to raise debt or equity is not always straightforward, and there may be trade-offs between the advantages and disadvantages of each option. Companies should carefully consider their financial situation and goals, consult with their advisors and stakeholders, and weigh the costs and benefits of each option before making a decision.
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