Question

Debate the advantages and drawbacks of using debt financing compared to equity financing to meet the financial needs of a start-up. Choose at least two examples of each type to compare and contrast.

Answer 1

For expanding the businesses, it is quite important for the businessmen to look for the various financial resources option. There are a number of financial resources which can be utilized by the business owners which can be classified into two main categories which are debt and equity.

Debt mainly incorporates the borrowing of money which has to be repaid along with some extent of interest while equity can be seen as raising the financial resources by selling the interest in the business organization.

Example of Debt:- The traditional form of debts such as borrowing from the banks and other financial institutions

Example of Equity:- It is mainly selling individual shares of the business organization to various interested investors.

The advantages of debt compared to equity are illustrated as below:-

• Due to the non-claim status of the lender on the equity in the business, the ownership interest of the owner does not get diluted in the organization due to debt.
• The lender will be receiving only the repayment of the mutually agreed principal of the loan along with the interest and there will be no direct claim in the future profits earned by the business. The larger portion of the reward will be enjoyed by the owner in case the business becomes successful
• Apart from the situation of variable rate loans, there will be a certainty about the principal and interest obligations and these can easily be forecasted and determined.
• The interest paid will be deducted from the tax return of the organization and thus lowering the real cost of the loan to the organization.
• There are fewer complications while raising finances through debt capital as there is no requirement for the organizations to adhere the state and federal securities laws and regulations.
• There is no requirement for the organization to send regular mails to a huge number of investors, holding periodic shareholders meetings and look for the vote for shareholders prior to take any action.

The disadvantages of debt compared to equity are illustrated as below:-

• There is a certain repayment point of debt as opposed to the equity.
• The break-even point of the organization is increased as the interest to be paid forms the fixed cost to the business. In fact, there can be greater risks of financial insolvency during difficult financial periods if the interest rates are quite high. The organizations find it quite difficult to grow due to the high cost of debt servicing which are highly leveraged.
• In order to pay both the interest and principal amounts, business requires regular cash flow and it must budget for these cash flows. Most of the loans are not repayable in different sums over a period of time on the basis of the business cycle of the organization.
• The activities of the organization are quite often restricted by the debt instruments and thus it obstructs the management from looking the various options of financing and non-core business opportunities.
• If a company has a larger debt-equity ratio, lenders and investors will treat it as a more risky organization. Similarly, the business is restricted due to the debt amount it can carry.