Debt F﷽inancing vs. Equity Financing: An Overview

When financing a company, "cost" is the measurable expense 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 ownไership stake in the business.

Debt Financing

When a firm raises money for capital by selling debt instruments to 澳洲幸运5官方开奖结果体彩网:investors, it is known as 澳洲幸运5官方开奖结果体彩网:debt financing. In return for lending the money, the individuals or institutions become 澳洲幸运5官方开奖结果体彩网:creditors and receive𒈔 a promise that the principal and interest on the debt will be repaid on a 🌌regular schedule.

Equity Financing

澳洲幸运5官方开奖结果体彩网:Equity financing is the process of raising capital through the sale of shares in a company. With equity financing comes an ownership interest for 澳洲幸运5官方开奖结果体彩网:shareholders. Equity financing may range from a few thousand dollars raised b𝓀y 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 usuall𝔍y 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 澳洲幸运5官方开奖结果体彩网:interest rate, or you can sell a 25 per𒈔cent 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 i꧅nterest expense (cost of debt financing) would be $4,000, leaving you with $16,000 in profit.

Conversely, had you 澳洲幸运5官方开奖结果体彩网:used equity financing, you would have zero debt (and, as a result, no interest expense) but would keep only♊ 75% of your profit (the other 25% 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, 澳洲幸运5官方开奖结果体彩网:to issue debt as opposed to equity. Taxes make the situation even better if you have debt since interest expense is deducted from earnings before 澳洲幸运5官方开奖结果体彩网:income taxes are levied, thus acting as a 澳洲幸运5官方开奖结果体彩网:tax shield (although we have ignored taxes in this example for the sake𒀰 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 澳洲幸运5官方开奖结果体彩网:fixed-cost nature of debt can prove too burdensome𓄧. 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 澳洲幸运5官方开奖结果体彩网:cash flows generally make 澳洲幸运5官方开奖结果体彩网:heavier use of debt financing than companies in risky industries or companies who are very small and just beginning operations. New businesses with h💝igh uncertainty may have a difficult time obtaining debt financing and often finance♋ their operations largely through equity.