A1. The 2007 financial crisis significantly reduced credit availability to businesses. When credit supply declines, only the most credit-worthy applicants have access to funding and even then the credit terms may not be as favorable as they are during normal times. Tight credit supply also means loans become more expensive due to higher interest rates. But times have improved and big banks are now boosting credit supply to businesses (Johnson & Chaudhri, 2014). As a result, businesses are more likely to get favorable terms and it may be better to go for debt funding in these economic times since debt funding tends to be cheaper than equity funding and interest on debt is tax-deductible.
Both debt and equity funding options have advantages and disadvantages. Debt doesn’t involve sacrificing a certain proportion of ownership and/or control of the business. If a business properly fulfills its principal and interest obligations, it can build an impressive credit history which further opens doors for favorable debt terms in the future. Interest on debt is tax deductible which positively affects liquidity. Debt funding may be even cheaper if the applicant has impressive credit history. One of the disadvantages of debt is that principal and interest obligations have to be met irrespective of the state of the economy or the performance of the business. Another disadvantage of debt funding is that it may not be available to new or small businesses on favorable terms (Harley, 2013). Debt funding also reduces profitability because of interest expense.
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When it comes to equity, funds do not have to be repaid back. Equity investors may also bring diverse range of expertise and experiences which is especially beneficial to new and/or small businesses. Equity funding is also suited to businesses with limited means or when economic conditions are difficult because it doesn’t threaten default of business and force it to go out of business, unlike debt funding. One of the costs of equity funding is that ownership and control is sacrificed to some extent. Equity funding may also turn out to be expensive in the long term if the business proves to be more successful than the original expectations of the founders.
A2. There are several strategies a business may adopt when selecting an investment banker. First of all, the business should make sure an investment banker has vast experience and understand the goals of the business in raising equity funds. A business should also make sure an investment banker understands its business well so that he/she can make a persuasive speech to potential investors and get the best terms on behalf of the client. A business should also seek out references for the investment banker to better understand his/her strengths and weaknesses. A business should also make sure the investment banker is trustable and can be relied upon to protect the best interests of the client. It also pays to have an investment banker with vast network of connections.
A3. Historical evidence suggests that there is a positive relationship between risk and return and it is true for both stocks and bonds. As one would expect, stocks are riskier than bonds and even more so than government-issued bonds and not surprisingly, stocks have also generated higher returns than bonds. Stocks earned 11.5% per year on the average between 1928 and 2013 and 10-year Treasury Bonds earned 5.21% per year on the average during the same year (Damodarana).
Diversification helps reduce risk in a portfolio because the stocks in the portfolio have different betas and weak co-relations with each other. This ensures they do not respond to changing market conditions in the same manner and the losses in some stocks are offset by the gains in others.
- Damodarana, A. (n.d.). Annual Returns on Stock, T.Bonds and T.Bills: 1928 – Current. Retrieved May 8, 2014. Web.
- Harley, K. (2013, June 25). The Difference Between Debt and Equity Financing for Your Small Business. Retrieved May 8, 2014. Web.
- Johnson, A. R., & Chaudhri, S. (2014, April 16). Big Banks Ramp Up Business Lending. Retrieved May 8, 2014. Web.
