Question

In what ways do the two sources of debt financing differ from each other? How do they differ from the two sources of equity financing? How would you choose between the two (debt financing and equity financing) as a financial manager?

Answer 1

Debt Financing means when a firm raises money for working capital or capital expenditures by selling bonds, bills, or notes to individual and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise to repay principal and interest on the debt.

The cost of capital i.e interest is fixed in this case.

Levered Capital structure.

Equity financing is the method of raising capital by selling company stock to investors. In return for the investment, the shareholders receive ownership interests in the company.

The cost of capital i.e dividend is not fixed in this case.

Unlevered Capital structure.

The amount of money that is required to obtain capital from different sources, called cost of capital, is crucial in determining a company's optimal capital structure.Equity financing refers to funds generated by the sale of stock. The main benefit of equity financing is that funds need not be repaid.Since equity financing is a greater risk to the investor than debt financing is to the lender, the cost of equity is often higher than the cost of debt.

If my income is sufficient to pay the debt interest then i will go with debt capital struture or else i will go with Equity structure.