June 13, 2024

Difference between Debt Financing and Equity Financing

Difference between Debt Financing and Equity Financing

Often businesses need external money to keep their operations going and invest in future growth. They can raise two types of capital: debt and equity. With debt, it’s the interest expense a firm pays on its debt. With equity, capital cost refers to the earnings claim given to the shareholders for their ownership interest in the business.

The amount of money required to get capital from various sources, called capital cost, is crucial in determining the optimal capital structure of a company. Capital cost is either expressed as a percentage or as a dollar amount, depending on the context.

Debt Financing

When a company raises capital money by selling debt instruments to investors, it is known as debt financing. The individuals or institutions become creditors in return for lending the money and obtain a promise to repay the principal and the interest on the debt on a regular schedule.

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Moreover, debt payments generally are tax-deductible. The drawback of debt financing is that lenders require interest payment, implying the total amount repaid is more than the initial amount. In addition, debt payments must be made irrespective of company revenue. This can be particularly dangerous for smaller or newer businesses.

Equity Financing

Equity financing is the process of capital raising through the sale of a firm’s shares. With equity financing comes shareholder ownership interest. Equity finance could range from a few thousand dollars brought up by a private investor to an initial public offering (IPO) on a trillion-dollar stock exchange.

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Shareholders buy stock with the understanding that afterward, they own a small stake in the business. The business is then binding on shareholders and must generate consistent profits to maintain a healthy valuation of the stock and pay dividends. Because equity financing is a greater risk for the investor than debt financing is for the lender, equity costs are often higher than the debt costs.

It is less expensive for you, as your company’s original shareholder, to issue debt rather than equity. Taxes make the circumstances even better if you have debt because interest expenses are deducted from earnings before income taxes are levied and thus act as a tax shield.

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Of course, the benefit of debt’s fixed-interest nature can also be a drawback. It introduces a fixed expense, thereby increasing the risk to a company. If a company does not generate enough cash, however, the fixed-cost nature of the debt can prove to be too burdensome. This basic idea signifies the debt-financing risk.

Companies are never entirely sure what their earnings will be (although they can make reasonable estimates) in the future. The more uncertain their future earnings, the greater the risk presented.

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As a result, firms in highly stable industries with consistent cash flows generally make more massive use of debt than firms in risky sectors or firms that are very small and just start-up operations. It may be difficult for new businesses with high uncertainty to obtain debt financing and often finance their operations primarily through equity.

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