Question

In a relation to ‘capital structure’ explain the relation between debt financing, equity financing and market value of an organization. Then, provide two different examples of the relation.

Answer 1

Solution

"Capital Structure" of a firm determines the composition of different sources of funds it uses to finance itself for carrying out it's operations and growth plans.These sources of funds are Debt and Equity.

Debt Financing:This is the process in which the firm chooses debt as the source of fund to raise capital.It borrowes money from different instituitions (or) individuals for definite time period (depending on the requirement) and in return compensates them in the form of paying interest. (which is generally fixed).

Advantage of debt financing is firms with good credit rating ; rather reputed /successful firms ones will be able to borrow capital at relatively lesser interest rates (as they are perceived to be less riskier),so they just need to pay interest amount at regular intervals of time.So they can make the maximum utilization of the capital in their growth / operation plans.

Equity financing : It is where capital is acquired by borrowing from individuals (or) institutions in return for a stake in the firm.

Relationship between Debt and Equity : Both are different types of borrowings so they are on the same side of the balance sheet i.e.,Liabilities.It is very essential for a firm to maintain a balance between Debt and Equity.More Debt indicates that the company is becoming more riskier.So as it becomes more riskier,the interest rate which it has to pay will be more.

More of the equity part indicates the more dilution of the stake in the company.A firm can re-think if it is the right decision for it to borrow capital and in-return providing them with the stake / ownership in their company.

There should be a balance between both debt and equity.The optimal ratio (but not necessary) is 2:1 which means debt can be two times of equity.

Firms with zero debt are valued more in the market.But you can utilize debt to reduce your tax liability.So in this process,firm can provide better return on equity for it's shareholders.

Firms generally opt for equity financing in their initial stages of business as it is difficult for them to borrow money from the market.In the intial stages firms generally have limited capital so they prefer using it to fuel their growth plans rather than to borrowing and paying money as interest on a regular basis.Example:Companies like Google and Microsoft generally do not pay dividends to the shareholders but instead utilize the money in their expansion plans.

Example:1.Startups (like Fisdom etc.,) opt for Equity financing because:

Cost of equity financing is relatively cheap as the market value of the firm is less in the inital days and also they can utitlixe the capital for growth rather than for interest payments ; it is not easy for them to borrow money from market as they are new and so perceived to be risky in nature.

2. In Capital intensive industries such as Infratructure,the firms will generally have very high levels of debt. so very high debt-to-equity ratios.So,if a firm is able to service the debt-obligations then it is completely fine for it to go for Debt financing.

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