Question

a) What are the key differences between equity and debt financing? Discus the merits and demerits of each type of procuring finance at the firm level.

b) What are Hedge Funds? What investment strategies do the hedge fund managers use?

Answer 1

The differences and merits and demerits of equity financing and debt financing are

The equity financing does not increase the liability of the company whereas a debt financing increases the liability of the company. This means that if the company is unable to provide any return to its investors, the investor cannot take any legal action against the company whereas if a company is unable to pay its debt the company will have to be liquidated and the debt holder will receive some or all of the money due to him. Thus increasing the equity liability does not increases the risk of the company, whereas increasing its debt would result in increased risk of the company which in turn would result in expensive debt for the company. Equity financing is more expensive for a company, meaning that a company needs to provide a higher return to its equity holders as compared to its bond holders as the risk taken by a equity holder is much more that a bond holder. This is because, as I wrote earlier, bond holder will guarantee get some or all of his money but a equity holder might or might not get any return. Thus the company compensates its equity holder by paying them more return for the extra risk they took. Also the return on equity paid by the company is not tax deductible whereas the return on debt is tax deductible. Another difference is that debt financing doesn't result in dilution of the company whereas the equity financing results in dilution of the company, which means that the more equity a company issues, the less governing power its current share holders will enjoy and if the majority of the stock of the company are with general public then all decisions needs to be taken through the majority decisions of the board of directors, whereas a debt financing does't result in the dilution of the company.

Answer b) Hedge funds are a kind of investment tool in which funds are generated by pooling the money from many investors and then investing the money in any type of financial security, in any proportion which would provide the desired return. Hedge fund managers can use whatever type of investment strategies they think would get them the desired result. Hedge funds are the least regulated investing vehicles and so they enjoy the freedom to invest on anything including stocks, bonds, bullion market, forex etc, in any proportion.