Capital is required for any business to flourish, and there are mainly two ways to raise capital.
Debt capital is also known as debt finance. Funding through debt capital occurs when a firm borrows money and agrees to pay it back to the lender later.
The most common types of use by debt capital firms are loans and bonds. These are the two most common ways that more significant firms use to fuel their expansion plans or fund new projects. Smaller enterprises could even use credit cards to raise their own capital.
A business that seeks to raise capital through debt may need to contact a bank for a loan, where the bank becomes the lender, and the business becomes the debtor. The bank charges interest in exchange for the loan, which the firm will note on its balance sheet along with the loan.
Another possibility is to issue corporate bonds. These bonds are sold to investors and mature after a specific date, also known as bondholders or lenders. The firm is responsible for issuing interest payments on the bond to investors before it reaches maturity. Because they generally come with a high risk — the chances of default are more elevated than government-issued bonds — they pay a much higher return. The company can utilize the money raised from bond issuance for its expansion plans.
Although this is a great way to raise much-needed money, debt capital comes with a downside: the additional interest burden comes. This expense, incurred just for the privilege of accessing funds, is called debt capital cost. Interest payments must be made to lenders, whatever the performance of the business. A highly leveraged company may have debt payments in a low season or a bad economy that exceeds its revenue.
Equity capital is generated not through borrowing but through the sale of company stock shares. If it is not financially viable to take on more debt, a company can raise capital by selling additional shares. These shares may be common shares or preferred shares.
A common stock gives shareholders voting rights, but it doesn’t provide much in terms of importance. If the company goes under or liquidates, it pays first to other creditors and shareholders. Before any such payments are made on common shares, preferred shares are unique because payment of a specified dividend is guaranteed. Preferred shareholders, in exchange, have limited ownership rights and have no voting rights.
The primary benefit of raising equity capital is that the firm must not repay shareholder investment, unlike debt capital. Instead, the cost of equity capital refers to the amount of return expected by investment shareholders based on the enormous market performance. These returns come from paying dividends and valuing stocks.
The disadvantage to equity capital is that each shareholder owns a small portion of the company, thus diluting ownership. Business owners are also accountable to their shareholders and must ensure that the company remains profitable while continuing to pay any expected dividends to maintain an elevated stock valuation.
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