Question

Two common forms of financing include debt and equity. Explain these financing options by defining them in your own words, discussing when each would be most appropriate, and providing an example that illustrates when each method might be preferred over the other. In replies to peers, discuss whether you support the definitions and examples provided using the topic materials.

Answer 1

Well, we all know it i.e., debt financing and equity financing.

The way of debt financing involves strict payment of interest to the debt provider. This is above the line cost to the company. Which means whether company earns profit or not in a financial year it has to pay this cost.

On the other hand we have equity way. As it is residuary, the payment of divided arises in cases where company earns profits and after taking reinvestment decisions. Equity holders are the owners and debt providers are investors (i.e., invests only with the intent of earn periodical return)

Debt forms are debentures and preferencial shares, loan from financial institutions or banks etc. All these has fixed interest cost. But it is not the case of equity mode which involves equity share capital.

Moreover debt is meant to be repayable after completion of fixed time period and again it is not the case for equity.

When it comes to preference between these two can be explained below.

We seen in above paras saying debt financing involves periodic payment of interest and repayment of principle after some time. So these are costs to the company. Because of this we can have tax savings. i.e., amount of interest cost multiplied by prevailing tax rate results in the savings in cost.

This is because interest cost is above the line item. But divided is below line item we can't get tax savings on this and moreover we need to pay divided distribution tax if applicable in the country. This is one thing which shall be consider while rising funds.

Second Merit is, risk and reward concept.

As equity holders are owners of the company they took ultimate risk (financial risk) and for the risk they taken they expects a return which is more than the risk they taken. Which means higher the risk higher will be the expected return. But in debt financing no such concept, because they get fixed interest payment irrespective of profit earned. Therefore equity holders return expectations are always high.

More and more debt infected into capital structure will results in higher required return for equity holders.