Costs of Issuing Equity
Issuing equity is an expensive manner to raise capital for a company. The costs incurred may differ, but they depend on the firms’ characteristics and the category of equity of the firm. Apex would incur various categories of expenses when issuing equity. The costs may be either direct or indirect. The following are the cost incurred in issuing equity; underwriting fee, Cost of underpricing, delays in registrations, asymmetrical information about stock price declines, and other expenses.
A firm or a company incurs an underwriting fee when issuing equity. The fee is collected by underwriters who manage the distribution and issuance of financial instruments. In other words, the underwriting fee is the cash collected for underwriting services. This cost is categorized as a direct cost.
Cost of Underpricing
The cost of underpricing can be defined as the pricing of a public offering below its initial price. Firms underprice the market value due to matters related to liquidity and stock trade uncertainty. Less liquidity means it would be difficult to predict the prices of shares. Therefore, the firm opts to reduce the price market value to reduce the investor’s risk. A reduction in the price market value of a public offering is an indirect cost to a firm. However, the market value increases with time because of the laws of supply and demand.
Delays in Registrations
Delays in registration may occur especially when traditional methods are adopted in equity issuances. The procedure used is lengthy, and it is an added expense when there is a delay in registration. Firms opt to use the shelf registration which is better than traditional registration. Shelf registration takes less time than the traditional method, and it takes few days to access the market.
Asymmetric information refers to a scenario whereby one party has better information than the other party. It is due to this reason that the parties involved make different decisions regarding economic phenomena. Asymmetric information affects the issuance of both debt and equity. It favors the issuance of debt more than the issuance of equity. This is because the debts reflect the boards’ confidence in the profitability of an investment. When the issuance of debt is preferred to the issuance of equity the prices of shares drops. This should be accounted as an indirect cost by a firm in equity issuance.
Advantages of Issuing Equity
Financing a firm using equity is advantageous since there is no mandatory payment for dividends. If a firm does not have sufficient cash to pay the dividends, it might skip payments of equity dividends. Also, the firm does not suffer from any legal consequences
Issuance of equity is advantageous since equity capital does not have maturity dates. Therefore, the firm has no obligation of compensating its investor.
Lastly, the issuance of equity improves the creditworthiness of a firm. Therefore, a firm can raise its debt finance with suitable terms.
Disadvantages of Issuing Equity
Issuance of equity is a disadvantage to the owners of firms since outsiders minimize the control owners have over their firms. They affect the decision-making process of a firm since they have a say in the final decision.
A high cost is incurred in the Issuance of equity compared to the other method of financing a firm. The shareholders’ rate of return is higher than the investors required rate of return. Also, the cost incurred such as underwriting is high. Therefore, it is not desirable to raise capital using this technique.
SEC Primary Requirements for an Initial Public Offering
According to Security and Exchange Commission (SEC) requirements, a firm or a company must use a Form S-1 in the registration of their securities. The commission requires the use of a form with a fill-in blank space when registering. Also, the form must be similar to a brochure, providing essential information about the firm or company.
In one of the requirements, the Commission emphasizes that a firm or a company should provide any credible information to make its disclosure complete. In other words, the disclosure should not be misleading to the investor. Therefore, the firm should inform the investor of the risk he or she may face in its prospectus.
The second requirement was confusing since most of the firms would shun such an explanation, for example, a firm would not mention the lack of business operation as a reason to seek Equity issuance. Definitely, investors would not like to invest in a firm that had collapsed. Therefore, this requirement may be a disadvantage to the firm.
The process of obtaining venture capital has fewer procedures than the issuance of securities. Although, in most cases, the issuance of equity is used in the financing of large firms while venture capital is used to finance small companies and firms.
Would it be optimal for Apex to seek venture capital instead of engaging in an initial public offering (IPO)? It would be optimal for Apex to engage in an initial public offering because it is an effective way of raising capital. Secondly, the issuance of equity turns investors into partial owners of a firm or a company. This makes it possible for investors to have a say in any decision made by the company. Thus, it minimizes the owners’ control of the firm of the company. Engaging the firm in an initial public offering would help it to retain a degree of control over its management. Therefore, it would attract great personnel who would improve the management of the firm.