Debt Financing vs Equity Financing: An Overview
When financing a business, the “cost” is the measurable expense of obtaining capital. With debt, this is the interest expense that a business pays on its debt. Along with equity, cost of capital refers to the claim on profits provided to shareholders for their participation in the business.
Key points to remember
- When financing a business, the “cost” is the measurable expense of obtaining capital.
- Along with equity, cost of capital refers to the claim on profits provided to shareholders for their participation in the business.
- If a business is expected to perform well, debt financing can usually be obtained at a lower effective cost.
When a company raises capital by selling debt securities to investors, it is called debt financing. In exchange for the loan of money, individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid on a regular schedule.
Equity financing is the process of raising capital through the sale of shares in a company. Equity financing comes with a right of ownership for the shareholders. Equity financing can range from a few thousand dollars raised by an entrepreneur from a private investor to an initial public offering (IPO) on a multibillion exchange.
If a business fails to generate enough cash, the fixed-cost nature of debt can prove too burdensome. This basic idea represents the risk associated with debt financing.
If a business is expected to perform well, you can usually get debt financing at a lower effective cost.
For example, if you run a small business and need $ 40,000 in financing, you can either take out a $ 40,000 bank loan at a 10% interest rate or sell a 25% stake in your business. to your neighbor for $ 40,000.
Suppose your business makes a profit of $ 20,000 in the next year. If you took out the bank loan, your interest expense (cost of debt financing) would be $ 4,000, leaving you $ 16,000 in profit.
Conversely, if you had used equity financing, you would have no debt (and therefore no interest charges), but would only keep 75% of your profits (the remaining 25% belonging to your neighbor). ). Therefore, your personal profit would only be $ 15,000, or (75% x $ 20,000).
From this example, you can see how much cheaper it is for you, as the original shareholder of your company, to issue debt versus stocks. Taxes make it even better if you were in debt since interest expense is deducted from profits before income taxes are taken, thus acting as a tax shield (although we have ignored taxes in this example for the sake of it. simplicity).
Of course, the advantage of the fixed rate nature of debt can also be a disadvantage. It presents a fixed expense, thus increasing the risk of a business. Going back to our example, suppose your business made only $ 5,000 in the following year. With debt financing, you would still have the same $ 4,000 in interest payable, so you only have $ 1,000 in profit ($ 5,000 – $ 4,000) left. With equity, you again have no interest charges, but only keep 75% of your profits, leaving you with $ 3,750 in profits (75% x $ 5,000).
However, if a business fails to generate sufficient cash flow, the fixed cost nature of debt can prove to be too burdensome. This basic idea represents the risk associated with debt financing.
The bottom line
Companies never know exactly what their profits will be in the future (although they can make reasonable estimates). The more uncertain their future profits, the higher the risk. As a result, companies in very stable sectors with constant cash flow tend to have a greater reliance on debt than companies in risky sectors or companies that are very small and are just starting out. New companies with high uncertainties can have difficulty obtaining debt financing and often fund their operations largely with equity capital. (For related reading, see âShould a Business Issue Debt or Equity?â)