Question

(A) Is it better to finance a company through debt or equity? Why?

Answer 1

Business often needs external money to maintain their operations and invest in future growth .There are two types of capital that can be raised :debt and equity.

Debt capital :

Debt financing is capital acquired through the borrowing of funds to be repaid at a later date .

Common type of debt are loans and credit .The benefit of debt financing is that it allows a business to leverage a small amount of money into much larger sum ,enabling more rapid growth than might otherwise be possible.

Equity financing :

The main benefit of equity financing is that funds need not to be repaid.

Since equity financing is a greater risk to the investor than debt financing is to the lender , the cost of equity is often higher than the cost of debt.

The amount of money that is required to obtain capital from different sources called cost of capital , is crucial in determining a company's optimal capital structure.

Cost of capital is expressed either as percentage or as dollar amount ,depending on the context.

The cost of debt capital is represented by the interest rate required by the lender . A $100000 loan with an interest rate of 6% has a cost of capital of 6% and total cost of capital $6000.however because payment on debt are tax deductible ,many cost of debt calculation take in to account the corporate tax rate .

Cost of equity calculations:-

The cost of equtiy financing required a rather straightforward calculation involving the capital asset pricing model or CAPM.:-

CAPM = risk free rate / company's beta × risk premium .