Businesses often need external moneyto maintain their operationsand invest in future growth. There are two types of capital that can be raised:debt and equity.
Debt Capital
Debt financing is capital acquired through the borrowing of funds to be repaid at a later date. Common types of debt are loans and credit. The benefit of debt financing is that it allows a business to leverage a small amount of money into a much larger sum, enabling more rapid growth than might otherwise be possible.
In addition, payments on debt are generally tax-deductible. The downside of debt financing is that lenders require the payment of interest, meaning the total amount repaid exceeds the initial sum. Also, payments on debt must be made regardless of business revenue. For smaller or newer businesses, this can be especially dangerous.
Equity Capital
Equity financing refers to funds generated by the sale of stock. The main benefit of equity financing is that funds need not be repaid. However, equity financing is not the "no-strings-attached" solution it may seem.
Shareholders purchase stock with the understanding that they then own a small stake in the business. The business is then beholden to shareholders and must generate consistent profits in order to maintain a healthy stock valuation and pay dividends. Since equity financing is a greater risk to the investor than debt financing is to the lender, the cost of equity is often higher than the cost of debt.
How to Choose Between Debt and Equity
The amount of money that is required to obtain capital from different sources, called cost of capital, is crucial in determining a company's optimal capital structure. Cost of capital is expressed either as a percentage or as a dollar amount, depending on the context.
The cost of debt capital is represented by the interest rate required by the lender. A $100,000 loan with an interest rate of 6%has acost of capital of 6%,and a total cost of capital of $6,000. However, because payments on debt are tax-deductible, many cost of debt calculations take into account the corporate tax rate.
Assuming the tax rate is 30%, the above loan would have an after-tax cost of capital of 4.2%.
Cost of Equity Calculations
The cost of equity financing requires a rather straightforward calculation involving the capital asset pricing model or CAPM:
CAPM=(Company’sBeta×RiskPremium)RiskFreeRate
By taking into account the returns generated by the larger market, as well as the individual stock's relative performance (represented by beta), the cost of equity calculation reflects the percentage of each invested dollar that shareholders expect in returns.
Finding the mix of debt and equity financing that yields the best funding at the lowest cost is a basic tenet of any prudent business strategy. To compare different capital structures, corporate accountants use a formula called the weighted average cost of capital, or WACC.
The WACC multiplies the percentage costs of debt—after accounting for the corporate tax rate—and equity under each proposed financing plan by a weight equal to the proportion of total capital represented by each capital type.
This allows businesses to determine which levels of debt and equity financing are most cost-effective.
FAQs
The simple answer is that it depends. The equity versus debt decision relies on a large number of factors such as the current economic climate, the business' existing capital structure, and the business' life cycle stage, to name a few.
Would you recommend a company to issue debt or equity? ›
Since Debt is almost always cheaper than Equity, Debt is almost always the answer. Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders' expected returns are lower than those of equity investors (shareholders). The risk and potential returns of Debt are both lower.
Why might a company choose to issue debt or equity? ›
Many fast-growing companies would prefer to use debt to support their growth, rather than equity, because it is, arguably, a less expensive form of financing (i.e., the rate of growth of the business's equity value is greater than the debt's borrowing cost).
Should a company have more debt or equity? ›
The greater the business risk makes equity the better choice for financing. This is the reason why start-ups are typically financed with equity. Lenders, by nature, are risk averse. Equity can also provide a base to support debt and increase the company's ability to raise additional funding.
Why should a company issue stock rather than debt? ›
If the venture for which the money needs to be raised does not have the ability to generate predictable cash flows in the immediate future, then the stock issue does make sense in such cases.
Why do firms prefer not to issue equity? ›
The business is then beholden to shareholders and must generate consistent profits in order to maintain a healthy stock valuation and pay dividends. Since equity financing is a greater risk to the investor than debt financing is to the lender, the cost of equity is often higher than the cost of debt.
Is it more expensive to issue debt or equity? ›
Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company's profit margins. Equity capital may come in the following forms: Common Stock: Companies sell common stock to shareholders to raise cash.
What are two disadvantages of using equity? ›
Disadvantages of Equity Financing
- The company gives up a portion of ownership.
- Leaders may be forced to consult with investors when making a decision.
- Equity typically costs more than debt financing due to higher risk.
- It is often harder to find an investor than to find a lender.
Raising Capital Through Preferred Stock
Preferred stock provides a simpler means of raising substantial capital than the sale of common stock does. The par value at which companies offer preferred stock is often significantly higher than the common stock price.
Why would a company issue more equity? ›
Essentially, the company can just issue more shares to the market as a secondary offering to attract investors. Investors buy those new shares. That allows the company to raise money and dilute ownership shares of existing investors in the process.
Which is better debt fund or equity fund? The choice between debt and equity funds depends on individual investment goals, risk tolerance, and time horizon. Equity funds offer higher potential returns but come with higher risk, while debt funds are safer but offer lower returns.
Why is debt good for a company? ›
Debt Can Generate Revenue
The revenue you generate from those activities can be used to both pay off the debt and to generate profit that your company can keep. But if you have equity partners, you'll have to share some of those profits with them.
What is the best debt-to-equity ratio for a company? ›
The maximum acceptable debt-to-equity ratio for more companies is between 1.5-2 or less. Large companies having a value higher than 2 of the debt-to-equity ratio is acceptable. 3. A debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations.
What is a disadvantage of issuing debt instead shares? ›
Disadvantages of Debt Compared to Equity
Unlike equity, debt must at some point be repaid. Interest is a fixed cost which raises the company's break-even point. High interest costs during difficult financial periods can increase the risk of insolvency.
Why is it good for a company to have no debt? ›
Reduces cash flow problems
Having a source of credit that is affordable for the company ensures there is capital there when it is needed. Debts can be paid when they are due, cash flow remains fluid, employees are paid and investment can be made for ongoing growth.
Why do firms prefer not to issue equity Quizlet? ›
- It prevents the adverse market reaction that tends to accompany a stock issue. Why do firms prefer not to issue equity? Share prices tend to drop when equity is issued.
Which is better for your business debt or equity financing? ›
Equity financing may be less risky than debt financing because you don't have a loan to repay or collateral at stake. Debt also requires regular repayments, which can hurt your company's cash flow and its ability to grow.
Why would a company want to know its debt-to-equity ratio? ›
Accesses financial health
The debt-to-equity ratio can help businesses assess their financial health and overall stability. A high ratio indicates a company might be funding too much of its operations with debt, which also indicates a high level of risk.
Why should a company issue equity shares? ›
Diversifying Ownership: Companies may issue shares to raise capital and diversify ownership. This allows new investors to become shareholders and can bring new perspectives and ideas to the company. Increasing Market Visibility: Companies may issue shares to raise capital and increase their visibility in the market.
What is better debt-to-equity? ›
The maximum acceptable debt-to-equity ratio for more companies is between 1.5-2 or less. Large companies having a value higher than 2 of the debt-to-equity ratio is acceptable. 3. A debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations.
