Business financing and capital structure decisions in marketplace competition

Capital Structure

For a small business, there are two major forms of financing. Debt is when the company borrows money. Debt for small businesses usually comes from a bank, and it often has a fixed schedule of repayments, and there is interest as well. The other form is equity, which is ownership in the business (Parker, 2012). Each has its advantages and disadvantages. Debt is risky, and indeed it increases the risk to the company because the payments must be made. As a result, the payments come from pre-tax earnings before there is money for reinvestment into the company or for disbursement to the shareholders. This obligation represents risk (Harley, 2013). Debt financing has two attractive advantages, however. The first is that it is cheaper than equity financing, and for a small business might be easier to acquire. The second is that debt financing allows for retention of ownership

With equity, a share of ownership is sold. The main advantage of this is that it allows for capital to remain in the company for reinvestment, rather than for debt repayment. This means that equity is the lower-risk of the two. However, by giving up a share in ownership, equity is more costly than debt. The big downside is the loss of equity. This not only costs the entrepreneur future profits but also there the entrepreneur has to be cognizant of losing control of the business, or selling 49% equity too early and backing themselves into a financing corner (Peavler, 2014).

With respect to raising capital, the big thing with an investment banker is that they have to come in at the right time, and they have to add value. Investment bankers are typically better at equity than debt financing, first of all. The reason for this is that debt is typically placed with just a few clients, or comes from a bank. Placing an equity issue and meeting the SEC's criteria for listing is far more complicated. That is a good job for the investment banker. It is not necessarily the case that the cheapest cost investment banker is best -- the objective is to raise the most amount of capital. This comes from a combination of the amount of capital raised less the fee. Ideally, you want the investment banker that maximizes the amount of capital raised.

Risk and return is usually higher for common stocks than for corporate bonds. There are a couple of reasons for this. The key is subordination. Debt financing must be paid first, from pre-tax dollars. Any equity disbursements come after debt disbursements, which means equity is riskier. In order to compensate for that risk, investors want their equity to earn more than debt. Thus, risk and return are related with debt and equity, and equity is riskier than debt is.

Diversification helps to reduce risk in a portfolio. Essentially, different stocks will move differently from each other. So if one stock is outperforming the market, another will be underperforming. Since investors cannot predict which stocks will behave in which way, the key is to have enough stocks in the portfolio that on average, the portfolio will be no riskier than the market as a whole. A perfectly diversified portfolio can be with just a few stocks but sometimes it takes a lot. The more stocks are in the portfolio, the more likely that portfolio is to be fully diversified.