Debt Financing vs Equity Financing – Which One is Better? |

By Trader Pit

July 7, 2021


Debt is the borrowing of money or a financial instrument that carries higher interest rates than the asset itself, and equity is the ownership of part or all of a company by its shareholders (shareholders are the owners of a company). Each of these debt and equity financing methods has its own pros and cons. Here is the information you need about the two:

Years ago we were taught that debt financing is better than equity financing. Why? So the question is, what are the differences between the two and are they really better for your business? This blog post will help you understand the pros and cons of each financing method and assist you in making an informed decision on which to go with.

The equity financing of a company can be better than the debt financing in the following  ways: 1. It can be the most cost effective financing option. 2. It gives the company the flexibility to grow and develop. 3. It can help the company to get out of debt. 4. It can help to build the business. 5. It can help the company to expand. 6. It can help the business to grow. 7. It can help the company to expand. 8. It can help the company to increase the efficiency of the business. 9. It can help the company to expand. 10. It can help the company to expand. 11. It can help the company to increase the market share. 12. It can. Read more about debt vs equity financing pros and cons and let us know what you think.The difference between debt and equity financing : Every business comes to a point where it needs to raise funds to support its growth or to survive, preferably the former. Capital needs are covered primarily by two financing options: debt and equity.

In this article, we will see what they are and which ones can be optimal. Read on to find out!

What is equity financing?

Equity financing involves raising capital through the sale of the founder’s share, i.e. part ownership of the company, in exchange for cash.

One of the main advantages of equity financing is that the company receives the funds without having to repay the principal.

This investment can be raised from the public through the markets by means of an IPO. Or in other cases by venture capitalists, angel investors, private equity funds, etc.

In addition to resources, the developer can benefit from the relationships, experience and familiarity that these new investors bring. After all, they too are interested in and benefit from the success of the company. In the case of an IPO, a company can benefit from being listed on the stock exchange.

However, there is a trade-off. In exchange for this money, the new shareholders receive a block of shares, which means they now have a say in the company and can vote on important issues.

This may affect the decisions of the company’s management as they now have to take into account the interests of the new shareholders.

The risks may also extend to successive promoters in management if they do not retain a material interest.

What is debt financing?

Debt financing involves borrowing money for a specific period of time with the intention of repaying the amount with interest. One of the most common methods of debt financing is borrowing from banks.

However, in debt financing the company also raises funds by selling bonds, debentures, etc. to its creditors.

In the case of debt financing, the amount must be repaid within a certain period and at a fixed interest rate.

One of the main advantages of debt financing is that a company can obtain funds without having to leave its founders. This allows them to maintain control of their business.

The lender has no control over the company and no say in its decision-making. Other benefits include tax advantages, as loans sometimes include depreciation and deductions.

The difficulty, however, is that the loan must be repaid. Even if the company goes bankrupt, the creditors are paid first. This can be a daunting task if the business is not yet profitable or experiencing difficulties. Funds can turn over and affect a company’s ability to grow.

You don’t believe me? Ask Anil Ambani. The former oligarch is still struggling to get out of the debt spiral, even after most of his companies had to close or sell due to too much debt.

Some examples

Too much financial jargon? We can understand these two sources of capital with an example:

Thus, Ineedfund Ltd is looking to raise a capital of Rs 50 lakh crore for its growth. The initiators have to sell 20% of the company’s shares to raise money.

On the other hand, the company has been offered a bank loan of Rs. 50 million, repayable in installments over 4 years at an interest rate of 5%.

Here the management or the promoters have two options. The first is to eliminate some problems that may affect future decision making. However, you are not obliged to repay the amount here. Developers can rest easy and not have to worry that their costs will increase.

On the other hand, they can also borrow from banks. In this case, the shareholders can keep their shares and manage the company as they see fit without being accountable to the new shareholders. On the other hand, they must constantly ensure that they repay the loan on time, as well as the interest.

The right decision here depends on a number of factors, which we will now examine.

Read fast

Are debts always bad for business?

Is debt cheaper than shares?

Debt is considered cheaper than equity because it involves additional risk borne by the new shareholders. In the event of bankruptcy, the company pays its creditors by first ceasing operations.

Shareholders can lose 100% of their invested capital. As a result, shareholders often expect and demand higher returns because of the increased risk. Moreover, their shares are even more vulnerable to market volatility.

Is debt so cheap?

While the cost of limited debt can be less than the cost of equity, too much debt can get a company into serious trouble. This is because there is interest on the debt that must be paid. An increase in debt directly leads to an increase in interest payments.

A downturn in the economy or other factors may affect a company’s ability to pay interest, putting it in the non-paying category. This increases risk for lenders, and this increased risk will in turn lead to higher borrowing costs.

It is indeed becoming more expensive to take out a loan today, as a higher interest rate is charged due to the increased risk. For holders of bonds and notes, this will also lead to them demanding higher yields.

These circumstances may also increase the risk to existing shareholders. When a company becomes insolvent, the effect of this news is reflected in the share price. Therefore, shareholders who own shares want to be compensated for this additional risk.

Debt or equity financing – which is better?

To find the answer to this question, look at a company’s weighted average cost of capital (WACC). The WACC calculates the cost of capital, and the calculation uses appropriate weights for each capital category.

The calculation includes both debt and equity. It is calculated as follows.

(Source: Fool.com)

(Source: CFI)

It should be noted that the WACC must always be balanced. If the WACC leans more towards point A, this indicates that the company has opted for too much equity and too little debt. However, the end result is a high capital cost.

If the WACC tends more towards point B, this indicates that the company has opted for too much debt and little equity. Again, the end result is high capital costs.

As can be seen from the graph, the most optimal point is point C. This point shows that the company has achieved a good balance between equity and debt. This indicates the healthiest cost of capital for the company.

If the company is already moving towards point A, it should try to offset its costs by financing its needs through debt. If, on the other hand, a company’s WACC is already tending towards point B, it should seek to compensate for it with equity.

Is the balance between debt and equity an absolute rule?

Not at all. Fundraising depends on a number of factors. They may include the phase of the business. When a company is going through a difficult period, it can sometimes be difficult to attract the interest of investors.

The company will be forced to borrow at higher interest rates. It is also possible that the company does not qualify for the loan at all, because for this too collateral is required.

The willingness of promoters to sell their shares also plays an important role. Moreover, the interest rate fluctuates constantly in the economy, making it profitable or not to borrow accordingly.

In addition, it is important to note that raising money through equity financing can also be expensive. Because the cost of an IPO is also high.

 

Short note
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Therefore, the company will also need sufficient funds to raise capital itself through an IPO.

Supplement

Ultimately, it is up to the business to choose the best source of funding. Depending on the situation, this may involve debt or equity financing.

It is also important for investors to be wary of excessive debt or equity financing. This can be determined by looking at the ratio of debt to equity of the company. The optimal leverage ratio ranges from 1 to 1.5, but it is not the only factor to consider when investing.

So much for this post. Let us know in the comments below what you think about companies being extremely cautious about debt lately. Have fun investing!

Aron, who holds a Bachelor of Commerce degree from Mangalore University, came into the world of equity research to explore his interest in financial markets. Outside of work he watches soaps, encourages the RCBs and dreams of going to Kasol as soon as possible. He also believes that eating ice cream with kids is the best way to teach them about taxes.When purchasing a home or going on a vacation, you may wonder how much it will cost. The answer is not always simple. Depending on where you live, the amount of money you have saved and the type of home you want, you can choose to finance the value of a home or travel with cash.. Read more about when should a company consider issuing debt instead of equity and let us know what you think.

Frequently Asked Questions

Should a company use debt or equity?

Debt is typically used when a company needs to borrow money to finance its operations. Equity is typically used when a company needs to raise money from investors.

Which is riskier debt or equity?

Debt is riskier than equity because it carries a higher risk of default.

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About the author

Trader Pit

A yogi who like Finance and Technology. I have been in Indian Stock market for over 12 years now as financial analyst, portfolio manager, trader. Now, I focus on Yoga, Financial Education & Long term investing. 

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