Question

To raise capital, corporate officers have two basic sources of funding from which to choose: (1) debt (i.e., issuing bonds, taking out a loan) or (2) equity (i.e., issuing more stock). What are the trade-offs between these two very different sources of capital? Consider tax and nontax factors.

Answer 1

Firstly, Funds should be raised in way that would yeild a maximum return at minimum cost. Finance can be chosen as a mix of debt and equity depending on the expected cash flow, tax savings and financial leverage. Let us consider each type of Finance in detail -

Debt financing - The definition of debt financing is borrowing money from a lender with the promise of paying back the borrowed amount over a predetermined period of time, plus interest. Debt financiang has a fixed commitment on payment of debt and interest. Interest payments are tax deductable and saves tax out flows. Debt financing ususally requires colltereal security and usually has covenants. Debt funds helps in financial leverage.

Equity Financing - The term equity is defined as ownership interest in a business. With equity financing, shares of the company is issued to friends, family and small investors, or as stocks by public companies. In Equity financing there is no fixed commitment on repayment. The cost of debt is generally higher as the returns is paid back as share of profits. There is no need to provide collateral security for equity instead investors are given share in ownership. Returns given as dividents/profit share are not tax deductable.

Let us examine advantages and disadvantages of Debt and Equity -

Debt Financing	Equity Financing
Advantages	Advantages
Fixed interest rate (There is no need to pay more if profits are more)	No fixed commitments
Tax deductable - After tax cost of debt will be (1-t)* r, where t is tax rate and r is interest rate of debt.	No need for collateral security
Financial leverage on equity	More flexibility for management is busniess operations
Less less cost of fund compared to equity	Dividents / profits can be distributed based on cash availability
No ownership sharing, better controls for management	Easier to finance from family/friends circle with much less risk.
Better discipline to management as there is a fixed commitment (need keep default risk at minimum)	No need to make payments if the company has no or very little profits.
Disadvantages	Disadvantages
More commitement and risk for management as repayments have to be made irrespective of earnings/cash flow	No Tax savings
Loss of future flexibility - there will be coventants for the debt. Future borrowning power will be restricted.	Less control for management as ownership is divided
Need to provide collateral security for amounts borrowed	Higher cost of capital as investors are taking more risk and expect more than general interest rates.
Getting a loan/issuing a bond is not easy as compared to rasing funds.	Limits long term upside potential for core investors as they have to divide profits.

In short

Raising money by selling equity in your company can be a smart move if you’re at an early stage and aren’t yet profitable, since you might not be able to repay a loan.

Borrowing money makes sense if you are certain the money will lead to a higher return than the total cost of capital.

A balance between the two is expected for any business.