Investment Financing

Organisations are faced with two alternative methods of financing when considering potential investment opportunities; debt and equity. But which is best? The answer is, there is no right answer. Both debt and equity financing have their benefits and criticisms, and the decision as to which path to choose is solely dependent on the company's circumstances.

Last week I briefly touched on equity financing when considering stock markets, this week I will focus on debt financing.

Debt financing is money raised through the use of loans, bonds or Euronotes. This method requires the repayment of the initial investment value, either at regular intervals or at the end of a fixed term period, as well as additional interest payments.

When considering debt financing there are two factors an organisation must take into account; the cost of capital, and the rate of return. In order to maximise shareholder wealth, chosen investments should always have a rate of return higher than the cost of capital. In my opinion this is a simple concept, but yet it seems some organisations choose to ignore this idea and invest in 'loss leader' projects, a typical example of this being Sony with it's PS3. In some instances loss leaders pay off, in others they don't. However, some firms just fail to take into account the cost of capital and the rate of return, entering into projects which are ultimately likely to fail.

This week it was announced that 3G and Berkshire Hathaway were to initiate a takeover of Heinz. Although the full extent of the takeover has not yet been disclosed, it is believed that the deal will result in over $12bn in debt, interest repayments and a yearly 9% dividend that will use up the majority of the company's cash flow. As the details of this investment is explained, it will be interesting to see whether this investment will turn out to be a successful loss leader project, or whether the returns verse cost have not been taken into consideration at all.

Although this investment has been criticised, it is a good example of what I believe is the best financing option available to firms. In this instance, the finance was raised through both equity and debt, thus providing the advantages of both techniques, whilst combating some of this disadvantages. in my opinion this is the better option for firms to invest in as it minimises the costs and risks involved in investments.