Question

Businesses rely on financing activities to fund their operating and investments. Explain the difference between owner and nonowner financing, and explain the benefits and risks involved in relying more heavily on each type of financing.

Answer 1

Owner financing refers to financing than the help of owners funds. This is called equity financing. Non-owner financing refers to the use of leverage or borrowed funds in the capital structure of the business.

Excessive use of equity results in higher cost of capital for the business because there is no tax benefit on use of equity. There is dilution of ownership and voting rights. However excessive use of equity results in higher credibility of the firm. There are lesser financial burdens on the company and lesser chances of bankruptcy due to noncompliance of debt burden. The other major benefit is that there is no compulsion to pay a dividend to the equity shareholders which can be paid at the discretion of the management.

Excessive use of debt on the other hand results in higher interest burden which can lead to bankruptcy of the firm in case of default. In most cases collateral is required. Also the debt has to be repaid at maturity which creates a burden on the firm. The major advantage of non owner financing is that the business receives a tax benefit on payment of interest. This lowers the cost of capital. Also the owner stake in the business is preserved.