Question

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What are some reasons that a company might choose common stock as means of financing their business rather than using debt? Also comment on why a company might choose debt over common stock.

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Answer 1

Ans - Reason for choosing equity over debt -

1. A company is pioneer stage- If the company is in pioneer stage that company chooses to opt for equity. The reason behind that in initial period it is very hard for startup to earn profits due to high cost associated with the project. So in case of debt, a company has to pay fixed amount of interest , no matters company is in profits or losses. So in that case a company opt for common stock for financing
2. .Reduction of risk - The interest payment of debt is mandatory even company are in losses. So a company has no obligation to pay some cash flow to common stockholders. This reduces the risk of debt burden but it will increase the required return of equity investors.
3. To earn capital profits- The company can issue shares at premium if company wants to earn capital profits. But there is no scope for earning profits in case of debt.
4. When company has ample growth opportunities- When company has ample growth opportunities it can finance through equity. As they don't have debt burden and all the profit will go in growth opportunities.

Reason for choosing debt over equity-

1. To get tax benefits- Sometimes a company issues debt to get tax benefits. Because it provides tax shield due to interest fall under expense category, which provide tax benefits.
2. When company wants to retain profits- If company wants to retain more profits either due to liquidity needs or for large expenditure, they can retain maximum amount to themselves by paying fixed amount of interest.
3. Debt is cheaper source of finance- Although there is no obligation of payment to equity shareholders but their required return is quite high as compared to debt. Debt has generally low risk due to regular payments and it is cheaper source of finance as compared to equity.
4. To obtain optimal capital structure- Sometimes company finances through debt to achieve optimal debt structure and to increase the earning per share. The optimal capital structure also increase the value of firm.