Question

Please read the following and respond with a minimum 100 word commentary at title link above. Your discussion should reflect original thoughts and opinions.

If you owned a business and needed to raise capital for future expansion, which option seems better- taking on debt (Ch. 6) or selling/issuing equity (Ch. 7) ? Under what circumstances would each be appealing to you?

Answer 1

Equity vs. Debt:

The two options are (1) issuing equity and (2) raising debt.

For the owner, issue of equity has the advantage of no committed cost. But it has a lot of disadvantages too. The equity offering will result in diluting stake which may, eventually lead to change of ownership and control of the company. On the other hand, debt financing does not involve share in equity and ownership. The obligation will cease on repayment of the debt along with interest as decided at the time of entering the agreement.

Equity, by nature, carries much more risk for the investor as well as the issuer. For investor, there is no assurance of repayment of the amount invested or for any income on it. It depends on the income generating capacity of the issuer. On the other hand, debt has a contractual obligation to repay the principal and pay interest at the agreed rate, at the agreed time. Hence, investors feel safer in investing in debt, compared to equity. This is notwithstanding the fact that equity investments offer unlimited potential for income in the form of capital gain and dividend income. But in the case of debt, income is pre-determined. For these reasons, the investors will demand higher return for equity.

Interest paid is an allowable expenditure for tax purposes, in most of the counties. Hence debt financing will help in reducing the tax burden. This benefit is not available in equity financing

Another limitation of equity offering is the extensive regulatory compliances involved in issuing equity and the high cost involved in floatation.

In addition to that, the unique advantage of the equity investor ie., unlimited potential for income generation, is a drain for the issuer. Hence, for a promoter, it is safer to issue debt/ borrow money rather than issue of equity.

Debt financing also has certain disadvantages as follows:

1. Cost and tough covenants: Though the established enterprises can command the market for very low interest rates with low or nil security, new entrepreneurs often face a difficult situation. They are made to pay much higher interest rate. Covenants will be tougher and will need high security.

2        Strain on cash flows: The loan terms contain repayment schedule and periodicity of interest payments. For a new venture, these often become not commensurate with the actual cash flows, resulting in strain on liquidity.

In view of the above, it is advisable to prefer debt financing, especially if the firm in high tax brackets or incidence of tax is high. This is more important in the event of the promoter’s stake is low and a takeover attempt cannot be ruled out.