Debt and equity financing: comparison and applications

Debt & Equity

Debt financing involves receiving capital in exchange for an obligation to repay that capital in the future. For this obligation, the company extending the credit will typically receive a payment in the form of interest. There are a number of different forms of debt financing. One is bonds, which are issued to the market. The issuing firm sells the bonds to investors and then repays according to a fixed schedule. The interest rate does not vary, but the value of the bonds will. Another form of debt financing is a revolving credit facility such as a line of credit. The type of debt is set up with a financial institution. The amount borrowed is not fixed, but is capped. The interest rate is often floating with revolving credit. The repayment schedule is negotiated by the parties as are other details of the agreement.

Equity financing refers to ownership in the company. There is no obligation but equity holders are entitled to a portion of the firm's earnings (dividends). In some cases, there are no dividends. In these cases, the value of the equity is related to the value of the company. There are a few different forms of equity financing. The first is the common share. These represent a stake in the company, and typically have voting rights that entitle the shareholder to a proportional degree of control with respect to the company's board, who act as agent for the shareholders. Another form of equity financing is the preferred share. This type of share is typically non-voting but receives a regular dividend. The preferred shareholders will be paid their dividend before the common shareholders under normal circumstances.

3) There is no right answer for which is preferable. The ideal capital structure for a firm will depend on the type of firm, its industry characteristics, its history and a whole host of other variables. The two different types of financing have different benefits, so the ideal capital structure will be that which maximizes the benefits in the context of the firm's operations.

Debt financing tends to have a lower cost than equity financing and is often easier to acquire. However, because debt financing represents a fixed obligation in terms of interest and repayment, it increases the risk of the firm. Thus, some amount of equity financing is ideal with respect to keeping the firm's risk level within reason. The level of risk a firm should have will vary depending on a number of variables. In some industries, cash flow is stable so more risk is reasonable; in other industries cash flow is unstable so lower risk is preferred.

Another consideration is control of the company. Because equity represents an ownership stake, firms often wish to control the amount of ownership stake that they surrender in their quest for financing. Debt financing is therefore sometimes preferable because it does not result in the surrendering of ownership stake. In some cases, preferred shares can be issued for this purpose, although their use is less common.