Question

(1) Explain the difference between debt and equity capital
(2) Give 3 examples each of debt security or capital, hybrid security or capital, and equity security or capital.
(3) What are the benefits of using debt capital?
(4) What are the costs of using debt capital?
(5) Identify six theories of capital structure and provide brief explanation

Answer 1

1.

Debt equity capital	Equity capital
1. Gives creditorship status to person who contribute money	1. Gives Ownership status to person who contributes
2. Do not enjoy voting rights.	2. Enjoy voting rights
3. Interest is paid for usage of money	3. Dividend is paid for usage of money
4. Have obligation to repay the debt and interest	4. No repayment of capital is made and no compulsion for company to pay dividend
5. Cost of capital is fixed	5. Capital cost are vary

2. Examples of

• Equity Capital: Common Stock, Mutual Funds, Exchange traded funds, etc
• Debt Capital: Certificate of deposits, Government Bonds, Debenture bonds, etc
• Hybrid securities: Equity Warrants, preference stocks, convertible bonds, etc

3. Benefits of using debt capital:

1. Ownership will be retai ned and not diluted.
2. Cost of debt capital is fixed. Hence can plan budgets accordingly.
3. Tax advantage of deductibilty of Interest.
4. Keeps the company leveraged.
5. Does not interfere management of the company.

4. Cost of debt capital is the interest rate that the organisation pays on the debt borrowed after considering the tax savings due to the same. It is Cost of debt, Kd = Interest(1-Tax)

6.

1. Traditional approach: It emphasizes on having the Optimal capital structure by the organisation.
2. Net Income approach: According to the theory, hange in capital leverage, will change the cost of capital
3. Net Operating Income approach: with an assumption of no taxes, this approach assumes that the cost of capital remains constant regardless of the financial leverage.
4. Modigliani Miller approach: This is based on 2 propositions:
   1. Value of 2 organisations will remain the same and will not be affected by the choice of finance used by the organisation.
   2. Financial leverage increases the value of a firm and reduces the cost of capital
5. Pecking Order theory: Companies shall first use internal financing followed by debt financing and then go for equity financing.
6. Irrelevance Proposition theorem: In the absence of agency costs and  taxes, the value of the firm is unaffected by the way it is financed provided the markets are efficient.