Question

What are the advantages and disadvantages of debt and equity financing?

Answer 1

Equity financing companies can raise finance by way of equity capital and it is one of the source of long term finance i.e.,selling shares of the company to investors in return the shareholders will get ownership interest in the company. Advantages of equity financing 1)equity capital provides a security in the form of equity base to the supplier of funds so a company with a high paid up equity capital can raise further funds from other sources easily. 2)less risky being a permanent source of finance it is to be repaid only in event of liquidation or winding up of the company. 3)there are no committed payments to holders of equity shares.dividends are discretionary not mandatory like interest on debentures. 4)equity shareholders are the owners of the company and have control over the management of the company. Disadvantages of equity financing 1)cost of equity shares is high and also flotation cost I.e., issue expenses are higher. 2)dividends are not tax deductible and hence there is no extra attraction for the company to issue equity shares. 3)uncertainty of dividend payment and capital gains to the investors. 4)issue of new or additional equity capital will reduce the EPS of existing shareholders unless profits are proportionately higher to accommodate it. 5)issue of new capital also reduces the ownership and control of existing shareholders. Debt financing in this method company raises capital through issuing debt I.e.,the funds for working capital or capital expenditures etc by selling debt instruments (bonds,notes,bills) to individuals or institutional investors like banks,in return for lending money to the company and the investors become creditors of the company. Advantages of debt financing 1)normally secured against the assets of the company and the principal amount has to be paid at some agreed future date so incase a company becomes bankrupt debentures holders rank first over equity shareholders on the liquidated asset. 2)very cheap source of raising funds because the cost is very low compared to equity capital thus gearing or leverage effect is advantageous to the companies with good ROCE. 3)there is no dilution of control as it does not give ownership right to the investors. 4)in a period of rising prices debt financing is advantageous because the fixed monetary outgo decreases in real terms as the price level increases. Disadvantages of debt financing 1)interest and capital repayment are obligatory payments so when companies are running short of funds or insufficient profits irrespective of this interest is to be paid. 2)debt financing also increases the financial risk associated with the firm. 3)credit rating is compulsory for public issue of debentures or private placement to mutual funds.