Question

Why would a company fund its operations by issuing equity rather than debt?

Answer 1

Why would a company fund its operations by issuing equity rather than debt?

A firm that needs money for long-term, general business operations can raise capital through either equity or long-term debt. Whether a firm uses debt or equity to raise capital depends on the relative costs of capital, the firm's current debt-to-equity ratio and its projected cash flow. Equity is a catch-all term for non-debt money invested in the company, and it normally represents a shift in the composition of ownership interests. Debt financing is generally cheaper, but it creates cash flow liabilities that the company must manage properly.

In general, equity is less risky than long-term debt. More equity tends to produce more favorable accounting ratios that other investors and potential lenders look upon favorably. Equity also comes with a host of opportunity costs, particularly because businesses can expand more rapidly with debt financing.

When a company wants to raise money, it has 2 options; issuing equity or debt. When a company issues equity, the company is getting cash from an investor and the investor is buying shares in the company. The company is not obligated or there is no mandatory condition that the company has to pay any interest on the equity money. Equity is risk capital and the investor makes money only if the company does well. And if the company does well, there is no issue paying back the investor.

However, in the case of a debt, all debt comes with an interest. The company has to pay a monthly rate of interest on the yearly rate of interest to the bank or the investor who is giving the company a debt. So, the challenge with issuing debt to raise capital is that a company will have to provide interest even if the company is doing well or not.

This could be adapting in situations where the company is not doing very well or the plantings are not going well according to projections. This is especially a situation, common with early stage start-ups. With early stage start-up they are not able to predict properly the future operations of the company, hence, no clarity to pay debt. Because of which early stage start-ups, especially technology will issue equity to raise money.