Debt vs Equity
They are essentially two ways a company can raise capital, they are by:
1) Borrowing money which becomes a debt to be settled at a later date, and
2) Equity which allows other people become partial owners of the business or company.
In a debt, a company raises money by selling financial instruments such as bonds, bills or notes to investors in order to finance its working capital or capital expenditure. In return for the money, the company pays an interest while also paying towards the cancellation of the principal itself. During this period, investors who buy the instrument issued by the company are known as the Creditors.
Equity on the other hand is the raising of capital through the selling of shares in an enterprise. In equity financing, ownership interests are sold and the buyer is availed the opportunity of a capital gain in his investments and also periodic dividends. He shares in excess profits, and he also bears the risk of loss if the business fails. Equities are sold through an Initial Public Offering (IPO). The company gets an investment bank to underwrite the shares or it can be in form of best efforts.
Underwriting could be used to raise money in debt or equity. In an underwriting the firm buys the entire offer and then resells to the public. There is a risk of not selling all the offers, and the investment bank bears this risk. To mitigate such risks, investment banks do a best effort or a syndicate underwriting. The best effort being an IPO in which the underwriter only agrees to do their best to sell the shares to the public. A syndicate is when investment banks come together to underwrite an IPO in order to share the risks. One underwriter leads the syndicates and the others sell a part of the security.
Debt requires the payment of a fixed rate of interest (usually referred to as coupon and derived by multiplying a fixed percentage on the principal amount) by the issuer to compensate the investor for tying up is money with the issuer instead of investing elsewhere. Equity holders on the other hand do not receive fixed interests; they only get returns after the debt holders have been settled. They receive returns in the form of dividends, and the good thing about equity is that a class of equity such as the common stock share in excess profits.
Lets now compare debts and equity and break down the advantages of one over the other.
Advantages of debt over equity for the company
- A lender is only entitled to the fixed rate of interest and the repayment of his loan to the company.
- He does not share in excess profits like the equity holders. This becomes advantageous when the finance gotten from debt alongside equity is used for the operations of the business and excess profit is made. The debt holder receives only his fixed rate of interest, and does not share in excess profits like the equity holder.
- Interests on debt is tax deductible and can be deducted on the tax returns. This reduces the overall amount of tax that would be paid thereby lowering the actual cost that would be paid.
- Raising debt capital is less stringent unlike the equity where due processes must be followed as stipulated by the state and federal securities laws and regulations.
- During planning, the cost of debt is already known and can be removed immediately because interest and principal payments are fixed.
- Debt does not reduce the owner’s ownership interest in the business.
Advantages of equity over debt for the company
- During the rough times, equity holders might not be paid and it is acceptable; but debt holders must be paid their interests at some point.
- Debts contain negative covenants that restrict the activities of the company thereby preventing them from pursuing alternative financing options and non-core business opportunities.
- When taking a debt most times a collateral is required so that in the case of default or liquidation, the asset may be sold off to pay back the debt.
- Interest is a fixed cost and this increases the break-even point.
- A highly leveraged company is at the risk of insolvency especially in a period where there is a depression in the markets or decline in the business of the company and interest rates remain fixed and must be paid.
- Cash outflow is required for the payment of interests and principal and it must be budgeted for.
Frank Fabozzi., Financial management and analysis