Last month, we explored the first three steps of FRICTO, a framework for analyzing asset-financing alternatives. As a reminder, FRICTO is difficult to apply to privately held electrical contracting firms in its entirety, since it relies on market-driven stock price for some calculations. However, the underlying decision factors apply to both public and private firms of all sizes, so the framework is relevant in focusing awareness on critical decision points affecting financing.
The first three steps—flexibility, risk and income—describe the analysis of financing alternatives, such as the sale of stock and increased debt load, as they affect the ability of the electrical contractor to survive unanticipated disasters, predictable risks and the impact on stock price and on the overall cost of financing. The final three steps are control, timing and other issues.
While other steps may show bias toward either debt financing or stock issues, control issues are neutral. Stockholders have less interest in control issues than company managers, whose vested interest is interwoven with their own job security and perhaps the composition of the board of directors. Stockholders, on the other hand, are focused on the appreciation of their investment and the dividends they earn. The shareholders elect the board of directors, which sets dividend policy and appoints the chief executive. Both of these decisions affect stock price.
Ownership structure and scope are related to control. The issuance of additional stock shares has the potential to change the balance of power among company owners. In privately held contracting firms, a few shareholders may hold large blocks of stock, and unless a large number of shares is issued—-perhaps to employees through an employee stock ownership plan (ESOP)—the status quo would not likely be affected.
There are no hard and fast calculations that apply to this step, although considerations related to ESOP implementation, or the awarding of stock shares to employees under a bonus plan, can become important if employees demand additional policymaking authority.
There are two major timing issues related to financing decisions. The first is the sequence of financing decisions, and the second is the status of the capital markets at the time financing is needed. For example, the decision to take on additional debt now, when low interest rates make it advisable, must be evaluated in the context of possible debt requirements for a subsequent large purchase in the following year. If the contractor incurs additional debt up to the maximum available level, it may be impossible to raise additional funds for future purchases.
The capital markets also may shift. For publicly traded companies, it is usually easier to raise more funds through the sale of equity (stock) than through debt financing, especially if interest rates on debt are likely to rise. However, if the price of company stock falls, it is much more difficult to raise the desired funds without diluting stock price and affecting the ability to pay expected dividends.
So, timing issues related to both interest rates and stock prices affect the decision to raise capital through debt or stock issues. Debt structure (short-term or long-term), the availability of funds, and stock prices all affect the choice of alternatives now and in the future.
In an ideal world, there would be no other issues. Managers would be able to analyze each of the other five steps with complete objectivity and clairvoyant knowledge of future trends and would be able to rely on the evidence. The reality is that managers have different levels of risk tolerance and may disagree on the relative importance assigned to the other five steps of the framework. Other issues arise from these differences in management viewpoint.
One such issue is how fast funds can be made available. A risk-averse manager may decide to issue stock if the current price is low enough to be attractive and interest rates are high or if the money markets are devoid of available funds, even though stock price may be diluted by this decision. The fact is that judgment plays an important part in financial decisions, and the best analytical evidence is often overridden by a strong intuitive choice. Complete objectivity in business decisions is an illusion. Fortunately, most high-level decisions are made by more than one individual, especially in large or publicly traded firms.
So, what is the use of an analytical framework if the final decision will most likely be left to personal judgment? Calculations provide objective support for major financial decisions, but perhaps the development of a refined intuitive compass is still a characteristic of the best leaders, particularly in high-risk industries. Electrical contracting, though built on technical expertise, is primarily a game of strategy, and the winners are those who can take a leap of faith when the rational evidence is imperfect.
NORBERG-JOHNSON is a former subcontractor and past president of two national construction associations. She may be reached at email@example.com.