Capital Structure: Debt vs. Equity Financing for Businesses

Introduction

In finance, capital structure refers to the manner in which a corporation finances its assets through some mixture of equity, debt, or hybrid securities (Atrill & McLaney, 2011). A firm's capital structure is the configuration of its long-term liabilities, and each firm can choose a different configuration depending on its industry and specific needs. Basically, a company has two traditional choices in capital financing.

The company can either sell equity, usually through the issuance of stocks or bonds, or it can sign a note with a traditional lender such as a bank, with which a specific payment structure will be associated with the loan. Each manner of financing capital has different strengths and weaknesses that may be relevant to a company depending on its circumstances and goals. This analysis outlines some of the advantages and disadvantages inherent in these choices as well as recommendations for businesses in today's market.

Advantages and Disadvantages of Capital Structures

The debt and equity methods of financing capital have many different strengths and weaknesses that may vary across different circumstances and industries. One of the first things to consider is the time frame desired for repaying the loan. For example, it is easier to finance short-term needs with debt financing. It is simply more convenient and practical to borrow from a traditional lending institution for a short-term loan than going to the market to issue stocks or bonds.

However, if financing is needed over a longer term or if the amount is larger, then equity financing may be justified. One of the main advantages of equity financing is that it can offer a business more flexibility in repaying obligations since repayment is tied to income, as in the case of issuing stocks. For example, if a company's profits decline, its stock liabilities would correspondingly be smaller. In the case of bonds, a company can generally finance a larger amount than with traditional sources. Furthermore, bonds make it easier to change ownership after the financing is funded because investors can simply buy and sell bonds on the market, since these assets are typically liquid.

In many cases it is advisable to have a professional investment banker assist in the financing arrangement. The role of an investment bank can be summarized as follows (Kuhn, 2011):

"Investment banks facilitate flows of funds and allocations of capital. They are financial intermediaries, the critical link between users and providers of capital. They bring together those who need money to invest (e.g., corporations that build factories and buy equipment) with those who have money to invest (e.g., institutions that manage money for pension plans), and they make the markets that allocate capital and regulate price in these financial transactions (i.e., who gets how many dollars, with what terms and at what cost)."

Thus, an investment banker can usually be an effective intermediary that facilitates funding from many different sources and offers a broad range of financing options.

Debt and Equity Comparison

The historical differences between stocks and bonds can be best explained by the levels of risk inherent for both the buyers and sellers of these financial instruments. For example, stocks carry the least risk for companies since they are tied to the company's performance, and repayment is flexible as it is tied to company performance. However, this increases risk to the stockholder, and thus they are often awarded a higher return for accepting this risk. By contrast, bonds can offer an organization more risk since they are tied to fixed repayment terms that the company may have difficulty meeting in the future.