Question

To get funding for the business you started in chapter 5, you have the option of debt versus equity financing. Please make the case of which type of financing you would pursue for your business and why? (25 points).

Answer 1

Equity Financing

Equity financing involves selling a portion of a company's equity in return for capital. For example, the owner of Company ABC might need to raise capital to fund business expansion. The owner decides to give up 10% of ownership in the company and sell it to an investor in return for capital. That investor now owns 10% of the company and has a voice in all business decisions going forward.

The main advantage of equity financing is that there is no obligation to repay the money acquired through it. Of course, a company's owners want it to be successful and provide the equity investors with a good return on their investment, but without required payments or interest charges, as is the case with debt financing.

Equity financing places no additional financial burden on the company. Since there are no required monthly payments associated with equity financing, the company has more capital available to invest in growing the business. But that doesn't mean there's no downside to equity financing.

In fact, the downside is quite large. In order to gain funding, you will have to give the investor a percentage of your company. You will have to share your profits and consult with your new partners any time you make decisions affecting the company. The only way to remove investors is to buy them out, but that will likely be more expensive than the money they originally gave you.

Debt Financing

Debt financing involves the borrowing of money and paying it back with interest. The most common form of debt financing is a loan. Debt financing sometimes comes with restrictions on the company's activities that may prevent it from taking advantage of opportunities outside the realm of its core business. Creditors look favorably upon a relatively low debt-to-equity ratio, which benefits the company if it needs to access additional debt financing in the future.

The advantages of debt financing are numerous. First, the lender has no control over your business. Once you pay the loan back, your relationship with the financier ends. Next, the interest you pay is tax deductible. Finally, it is easy to forecast .

Equity Financing vs. Debt Financing: An Overview

To raise capital for business needs, companies primarily have two types of financing as an option: equity financing and debt financing. Most companies use a combination of debt and equity financing, but there are some distinct advantages to both. Principal among them is that equity financing carries no repayment obligation and provides extra working capital that can be used to grow a business. Debt financing on the other hand does not require giving up a portion of ownership.

Companies usually have a choice as to whether to seek debt or equity financing. The choice often depends upon which source of funding is most easily accessible for the company, its cash flow, and how important maintaining control of the company is to its principal owners. The debt-to-equity-ratioshows how much of a company's financing is proportionately provided by debt and equity.

KEY TAKEAWAYS

• There are two types of financing available to a company when it needs to raise capital: equity financing and debt financing.
• Debt financing involves the borrowing of money whereas equity financing involves selling a portion of equity in the company.
• The main advantage of equity financing is that there is no obligation to repay the money acquired through it.
• Equity financing places no additional financial burden on the company, however, the downside is quite large.
• The main advantage of debt financing is that a business owner does not give up any control of the business as they do with equity financing.