Equity and Debt Capital Structure Essay

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AMSC had announced a letter of intent for secured debt financing in July of 2003 (AMSC 2003 Annual Report) when the stock was trading in the range of $8 per share. The blackout gave the firm's stock considerable momentum, and it finished the month of August up over 50% at $12.19 per share (MSN Moneycentral, 2010). Equity issues normally result in dilution of the stock price, since the issue must be offered at a discount to the current price in order to attract investors. With the stock price spike, however, such a discount would still be above the July price, or indeed any price the company's stock had seen in the previous 18 months. Thus, the impacts of the dilution would be minimal to the existing shareholders.

The decision may also have been made on the basis of capital structure. At the time, AMSC did not have any long-term debt. The July financing would have been the only long-term debt for the company. The firm had very strong liquidity ratios. Thus, the decision to issue equity also relates to management's aversion to debt. Debt aversion is one reason for choosing equity despite its higher cost. Firms sometimes prefer to match their financing terms with their revenue terms. A company focused on long-term growth or growth of indeterminate length may prefer to utilize equity financing specifically because of the flexibility it gives management.

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At AMSC, there was no reason given the firm's size and finances to have debt aversion, yet such aversion may simply have become an ingrained part of the managerial culture.

The other major financial consideration is the firm's current cash flow situation. While AMSC had a strong balance sheet at the time, it was losing money. The loss in fiscal 2003 was $4.21 per share, and had been rapidly increasing over the past few years. Although AMSC was an established business, one of its main lines of business, contracts, had dried up. Contract revenues declined from $3.1 billion in 2001 to $715 million in 2003. Contracts represent steady income flows that can easily be applied to debt. Without any certainty from this particular income stream, debt financing may have appear unattractive to management as it worked to grow different businesses, perhaps with less certain cash flows.

The decision by AMSC management to choose equity financing therefore appears to be the result of three different factors. The company had a cultural aversion to debt. The company also was in a transitional phase of its business, with steady contract income streams drying up. Lastly, AMSC's share price had spiked, reducing the negative impact to the shareholders of an equity issue. These three factors combined convinced management to forgo the debt issue and issue more.....

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