Question

When a company decides to finance a new project, they can either borrow money via bonds or issue stock. What are the advantages and disadvantages of each option? Explain your reasoning.

Answer 1

Debt financing: Raising funds via issuing bonds, debentures, etc.

Advantages:

• No dilution of control: The lender does not have control over the affairs of the borrower.
• No dilution of ownership: The lender does not have any ownership stake in the entity. Thus, the shareholders retain full ownership.
• Tax savings: Interest on debt is allowed as a deduction for tax purposes. Whereas, dividend paid to equity holders are not allowed as a deduction for tax purposes.

Disadvantages:

• Fixed obligation: The borrower must make periodic payments by way of interest even if no profits are earned.
• Repayment: The borrower must repay the principal as per the terms of repayment.
• Collateral: The borrower might need to provide security by pledging the assets of the business.

Equity financing: Raising capital by selling stocks of the company.

Advantages:

• Lower risk: There is no obligation to make fixed payments by way of dividends. Thus, in the absence of profits or during difficult times, the company can decrease or suspend dividend payments.
• Permanent source of finance: There is no obligation to redeem the stock.
• Expansion of financial base: It expands the capital base and increases the further borrowing powers of the company.
• Credit problems: Startups and new ventures having credit problems find equity financing easier due to the unavailability of debt financing or higher interest rates.

Disadvantages:

• No tax savings: The dividends are not allowed as a deduction for tax purposes.
• Dilution of ownership and control: Issue of new stock will dilute the ownership and control of the existing stockholders.