Question

Paul Powell owns Powell’s Pickles, a small pickle manufacturer.   The business has done really well and Paul wants to expand by opening another factory. He needs about $5 million and he is deciding whether to issue stock or bonds.

Explain the difference between debt and equity and also the advantages and disadvantages of issuing stock or bonds, then make a recommendation as to which he should do.

Answer 1

Difference between debt and equity

• The shares are the company's own fund while the debentures are the borrowed funds of the company.
• Shares represent the capital of the company while debentures represent the debt of the company.
• The holder of shares is called as shareholder while the holder of debentures is known as debenture holder.
• Shareholders get the dividend and they are owners while debenture holders get the interest and known as creditors.
• The dividend can be paid to owners only out of profits while interest can be paid to debenture holders even if there is the unavailability of profit.
• The dividend is an appropriation of surplus or profit and so it is not permitted as deduction while Interest is an expense and so it is permitted as a deduction from profit.
• No security of payment in shares while there is proper security for debentures.
• The holders of shares have voting rights while the holders of debentures do not have any voting rights.

Advantages of debentures:

• Debentures are a safe investment and offer security to conservative investors.
• You get interest payments irrespective of whether a Company is making a profit.
• Raising capital via dividends is less costly.
• The Company doesn’t need to dilute equity. It can raise long-term finance at lower rates.
• Companies can expand using money provided by the debenture holders.

Disadvantages of debentures:

• Companies with fluctuating income must not opt for debentures.
• A Company pays interest on debentures, irrespective of whether it makes a profit.
• Debenture holders do not enjoy voting rights.
• In a recession, Company may not be able to pay debenture interest.
• Debentures are secured against assets, making it difficult for Companies to raise further loans and advances.

• Shares can not be converted into debentures but debentures can be converted into shares.
• Shares are paid after the payment of all the liabilities debentures get priority over shares, and so they are repaid before shares.

Advantages of Issuing Equity Shares:

1. Equity shares do not make any commitment to pay a fixed rate of dividend.

2. Equity shares can be issued without producing any charge over the assets of the company.

3. It is a constant source of capital and the company has to repay it except under liquidation.

4. Equity shareholders are the main owners of the company who have the voting rights.

5. In case of profits, equity shareholders are the genuine gainers by way of enhanced dividends and appreciation in the value of shares.

Disadvantages of Issuing Equity Shares:

1. If only equity shares are issued, the company cannot take the benefit of trading on equity.

2. As equity capital cannot be redeemed, there is a threat of over capitalisation.

3. Equity shareholders can put barriers for management by manipulation and organising themselves.

4. During prosperous periods higher dividends have to be paid leading to improve in the value of shares in the market and it directs to speculation.

5. Investors who want to invest in safe securities with a fixed income have no temptation for such shares.

What method of issuing capital should the company use completely depends on the context. If the firm is highly leveraged financially(high debt-equity ratio), it is beneficial to issue equity. If it has very little debt, it may raise more equity. While it is generally said that cost of equity is higher than the cost of debt, equity provides the freedom of deferring the payments(dividends) while in case of debt, the borrower is mandated to pay as soon as the debt is issued. In this case I think its more convenient and best way to gather capital by issuing shares of the company. Because of the advantages equity shares hold over debentureholders.

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