Debt Financing
When a firm raises money for capital by selling debt instruments to investors, it is
known as debt financing. In return for lending the money, the 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
Equity financing is the process of raising capital through the sale of shares in a
company. With equity financing comes an ownership interest for shareholders.
Equity financing may range from a few thousand dollars raised by an entrepreneur
from a private investor to an initial public offering (IPO) on a stock exchange running
into the billions.
Example
Provided a company is expected to perform well, you can usually obtain debt
financing at a lower effective cost.
For example, if you run a small business and need $40,000 of financing, you can
either take out a $40,000 bank loan at a 10 percent interest rate, or you can sell a 25
percent stake in your business to your neighbor for $40,000.
Suppose your business earns a $20,000 profit during the next year. If you took the
bank loan, your interest expense (cost of debt financing) would be $4,000, leaving
you with $16,000 in profit.
Conversely, had you used equity financing, you would have zero debt (and as a
result, no interest expense), but would keep only 75 percent of your profit (the other
25 percent being owned by your neighbor). Therefore, your personal profit would
only be $15,000, or (75% x $20,000).
From this example, you can see how it is less expensive for you, as the original
shareholder of your company, to issue debt as opposed to equity. Taxes make the
situation even better if you had debt since interest expense is deducted from
earnings before income taxes are levied, thus acting as a tax shield (although we
have ignored taxes in this example for the sake of simplicity).
Of course, the advantage of the fixed-interest nature of debt can also be a
disadvantage. It presents a fixed expense, thus increasing a company's risk. Going
back to our example, suppose your company only earned $5,000 during the next
year. With debt financing, you would still have the same $4,000 of interest to pay, so
you would be left with only $1,000 of profit ($5,000 - $4,000). With equity, you again
have no interest expense, but only keep 75 percent of your profits, thus leaving you
with $3,750 of profits (75% x $5,000).
However, if a company 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.
The Bottom Line
Companies are never totally certain what their earnings will amount to in the future
(although they can make reasonable estimates). The more uncertain their future
earnings, the more risk is presented. As a result, companies in very stable industries
with consistent cash flows generally make heavier use of debt than companies in
risky industries or companies who are very small and just beginning operations. New
businesses with high uncertainty may have a difficult time obtaining debt financing
and often finance their operations largely through equity.
KEY TAKEAWAYS
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When financing a company, "cost" is the measurable cost of obtaining capital.
With equity, the cost of capital refers to the claim on earnings provided to
shareholders for their ownership stake in the business.
Provided a company is expected to perform well, debt financing can usually
be obtained at a lower effective cost.
Debt Financing vs. Equity Financing: An Overview
When financing a company, "cost" is the measurable cost of obtaining capital.
With debt, this is the interest expense a company pays on its debt. With equity, the
cost of capital refers to the claim on earnings provided to shareholders for their
ownership stake in the business.
Sometimes, funds may be suddenly required. Equity investments maybe in downturn
at that time. Redeeming the investment at that point in time may incur losses.
Some debt funds, such as gilt funds, generate high returns in situations like falling
interest rates in the market.
Debt and Equity market
The debt market, or bond market, is the arena in which investment in loans
are bought and sold.
Investments in debt securities typically involve less risk than equity investments and
offer a lower potential return on investment. Debt investments by nature fluctuate
less in price than stocks. Even if a company is liquidated, bondholders are the first to
be paid.
Bonds are the most common form of debt investment. These are issued by
corporations or by the government to raise capital for their operations and generally
carry a fixed interest rate. Most are unsecured but are issued with a rating by one of
several agencies such as Moody's to indicate the likely integrity of the issuer.
The primary difference between secured and unsecured debt is the presence or
absence of collateral—that is, backing for the debt, or something to be taken as
security against non-repayment.
Unsecured Debt
Unsecured debt has no collateral backing: It requires no security, as its name
implies. If the borrower defaults on this type of debt, the lender must initiate a
lawsuit to collect what is owed.
Lenders issue funds in an unsecured loan based solely on the
borrower's creditworthiness and promise to repay. Therefore, banks typically
charge a higher interest rate on these so-called signature loans. Also, credit
score and debt-to-income requirements are usually stricter for these types of
loans, and they are only made available to the most credible borrowers.
The equity market, or the stock market, is the arena in which stocks are bought and
sold. The term encompasses all of the marketplaces such as the New York Stock
Exchange (NYSE), the Nasdaq, and the London Stock Exchange (LSE), and many
others.
The equity market is viewed as inherently risky while having the potential to deliver a
higher return than other investments.