Question

Research and then discuss the implications of financing through debt as they compare to financing through equity.

What are the pros and cons of each method?

Which method would you use to raise capital for your business?

Answer 1

When a firm raises money for capital by selling debt instruments to investors, it is known as debt financing. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid on a regular schedule.Companies are never totally certain what their earnings will amount to in the future (although they can make reasonable estimates). The more uncertain their future earnings, the more risk is presented. As a result, companies in very stable industries with consistent cash flows generally make heavier use of debt than companies in risky industries or companies who are very small and just beginning operations. New businesses with high uncertainty may have a difficult time obtaining debt financing and often finance their operations largely through equity.

1) Debt financing:

Pros of Debt financing:

• Control: Taking out a loan is temporary. The relationship ends when the debt is repaid. The lender does not have any say in how the owner runs his business.
• Taxes: Loan interest is tax deductible, whereas dividends paid to shareholders are not.
• Predictability: Principal and interest payments are stated in advance, so it is easier to work these into the company's cash flow. Loans can be short, medium or long term.

Cons of debt Financing:

• Qualification: The company and the owner must have acceptable credit ratings to qualify.
• Fixed payments: Principal and interest payments must be made on specified dates without fail. Businesses that have unpredictable cash flows might have difficulties making loan payments. Declines in sales can create serious problems in meeting loan payment dates.
• Cash flow: Taking on too much debt makes the business more likely to have problems meeting loan payments if cash flow declines. Investors will also see the company as a higher risk and be reluctant to make additional equity investments.
• Collateral: Lenders will typically demand that certain assets of the company be held as collateral, and the owner is often required to guarantee the loan personally.

2) Equity Financing:

Pros of equity Financing:

• Less risk: You have less risk with equity financing because you don't have any fixed monthly loan payments to make. This can be particularly helpful with startup businesses that may not have positive cash flows during the early months.
• Credit problems: If you have credit problems, equity financing may be the only choice for funds to finance growth. Even if debt financing is offered, the interest rate may be too high and the payments too steep to be acceptable.
• Cash flow: Equity financing does not take funds out of the business. Debt loan repayments take funds out of the company's cash flow, reducing the money needed to finance growth.
• Long-term planning: Equity investors do not expect to receive an immediate return on their investment. They have a long-term view and also face the possibility of losing their money if the business fails.

Cons of equity Financing

• Cost: Equity investors expect to receive a return on their money. The business owner must be willing to share some of the company's profit with his equity partners. The amount of money paid to the partners could be higher than the interest rates on debt financing.
• Loss of Control: The owner has to give up some control of his company when he takes on additional investors. Equity partners want to have a voice in making the decisions of the business, especially the big decisions.
• Potential for Conflict: All the partners will not always agree when making decisions. These conflicts can erupt from different visions for the company and disagreements on management styles. An owner must be willing to deal with these differences of opinions.

The decision for which method of financing would I use for my business depends on the certainity of my future earning. If i am certain of a good earning in future I will prefer debt financing as it will make sure that I dont lose control of my business at the same time have full ownership. but If, I am sceptical of my future conditions I will go for equity financing. The best method of financing will be to use both the methods in a balance proportion.