Debt Financing vs. Eqꦍuity 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 pr🗹ovided to shareholders for their ownership stake in the business.

Debt Financing

When a firm raises money for capital by selling debt instruments to 澳洲幸运5开奖号码历史查询:investors, it is known as 澳洲幸运5开奖号码历史查询:debt financing. In return for lending the money, the individuals or institutions become 澳洲幸运5开奖号码历史查询:creditors and receive a promise that the princ𒈔ipal and interest on the debt will be repaid o♎n a regular schedule.

Equity Financing

澳洲幸运5开奖号码历史查询: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开奖号码历史查询:shareholders. Equity financi🦄ng 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 effect🐻ive 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开奖号码历史查询:interest rate, or 🍰you can sell a 25 percent stake in your business to your neighbor for $40,000🦄.

Suppos🐻e your business earns a $20,000 profit during the next year. If you took the bank loan, your interest expense (cost of debt financing) wou🙈ld be $4,000, leaving you with $16,000 in profit.

Conversely, had you 澳洲幸运5开奖号码历史查询: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% bei💦ng 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开奖号码历史查询: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开奖号码历史查询:income taxes are levied, thus acting as a 澳洲幸运5开奖号码历史查询:tax shield (although we have ignored taxes in this examౠple 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 澳洲幸运5开奖号码历史查询: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 澳洲幸运5开奖号码历史查询:cash flows generally make 澳洲幸运5开奖号码历史查询:heavier use of debt financing than companies in risky industries or companies who are very small and just beginning operations. New businesses with high uncertain𝓰ty may have a difficult t🌊ime obtaining debt financing and often finance their operations largely through equity.