Question

Compare and contrast the characteristics of equity and debt. What are the advantages and disadvantages of each from the company’s perspective?

Answer 1

The primary difference between debt and equity financing is the type of instrument the company issues in order to raise the capital it needs. With equity financing, a company raises capital by issuing stock. In debt financing, the company issues debt instruments, such as bonds, to raise money.

Both debt and equity financing are the means that a company or business may use to raise the money it requires for expenses, a special project or other business expense. Both debt and equity financing raises cash for the business, but by different means. The two different instruments also tend to attract different investors.

When a company issues equity financing, then the individual or company buying the stock becomes part owner of the business. Under these circumstances, the stockholder owns equity or a piece of ownership in the business. The more stocks the person holds, the higher their ownership interest in the company. An individual that invests in stocks tends to desire ownership interest in a company and wants to choose when and if they relinquish ownership.

When a debt instrument is used to raise cash, then the company issuing the debt is also required to pay interest on the debt instrument to the holder of the bond. The challenge with debt financing is that the interest rate on the instrument has to be high enough to entice buyers to buy. In addition, the riskier the need for the cash is, the higher the interest rate on the debt instrument must be in order to entice the number of investors the company needs to raise the capital it requires.

Someone who invests in bonds is typically more of a conservative investor than a stock investor. A bond investor is also in it for the length of the bond or until the bond matures. This means that the buyer of the bond knows when they will receive the return on their investment. Bond returns are also guaranteed, while neither of these are the case when someone invests in stocks.

Stock holders may not receive a return on the investment because stock prices fluctuate. While bond prices fluctuate when someone buys a bond, they are guaranteed the interest payments and the face value of the bond when the bond matures. The level of risk is another difference between debt and equity financing — debt financing is less risky to investors than equity financing.