Businesses in their initial years often need external funds in order to maintain their operations and invest in future growth.
Finding that money can be a real challenge. There are these basic funding options which small entrepreneurs can avail: Debt and equity. Each type has its own share of pros and cons.
What Is Debt Capital?
Debt financing is the capital acquired through the borrowing of funds to be repaid at a later date. Loans and credits are common debt types. The good side of debt financing is that it allows a business to leverage a small amount of money into a much larger sum which enables rapid growth of the business.
There are both benefits and drawback of debt financing which we can understand in detail below:
Pros of debt financing
- Complete ownership: It becomes your obligation to make the agreed-upon payments on time when you borrow from the bank or another lender and that’s the sole obligation. You retain the right to operate your business in your own way without any outside interference. In equity financing though, the investors attain company ownership along with the control over management decisions. You often will have to seek approval for a mutually agreed list of items, ranging from hiring new personnel to selecting vendors. Virtually all equity investors seek some level of authority in the decision-making process of companies that they invest in.
- Tax deductions: This is the biggest benefit of debt financing. The potential tax deduction you can take for the interest that accrues on debt is certainly appealing. Regardless of whether they’re charges from a term loan, line of credit or working capital account, any interest paid on money that you borrowed for business activities is tax deductible.
- Lower interest rate: Because of various tax advantages of debt financing, you’ll need to adjust your interest rate while comparing debt financing to alternative financing options. Let’s imagine that you were evaluating whether or not to take a loan with an interest rate of 14%. Assuming that your business tax rate was 25%, your after-tax interest rate is 10.5% (14% – (1 – 25%)). When bringing taxes into the picture, 10.5% would be the actual interest rate that you would need to use in forecasts about your business. This is one of those times in which taxes can actually help you improve your bottom line.
Cons of debt financing
- Repayment of loans: Even though in debt financing, the sole obligation is to pay back on time it becomes a real challenge if your business fails. Also, the lenders will have a claim for repayment before any equity investors if you’re forced into bankruptcy.
- High-interest rates: Even after calculating the discounted interest rate from your tax deductions, you might still be faced with a high-interest rate because these will vary with macroeconomic conditions, your history with the banks, your business credit rating and your personal credit history.
- Impacts on your credit rating: It becomes the need of an hour to bring money on debt when your firm is just starting up but each loan will be noted on your credit report and will affect your credit rating. The more you borrow, the higher the risk becomes to the lender so each subsequent loan comes with a higher interest rate.
- Cash and collateral: Even if you plan to use the loan to invest in an important asset, you’ll have to be sure that your business will generate sufficient cash flow by the time repayment of the loan is scheduled to begin. You’ll also most likely be asked to put up collateral to protect the lender in the event that you default on your payments.
What Is Equity Capital?
Equity financing refers to funds generated by the sale of stock. The primary advantage of equity financing is that funds need not be repaid. Shareholders purchase stock with the expectation of owning a small stake in the business. The business must generate consistent profits in order to maintain a healthy stock valuation and pay dividends. Since equity financing is a greater risk to the investor than debt financing is to the lender, the cost of equity is often higher than the cost of debt.
Pros of equity financing
- More liquid funds-You don’t have to pay interest on the capital you raise, so there’s no need to put your business’s profits into debt repayments. This means you’ve got more cash available to grow your business.
- Long-lasting relationships-With the right investors, you can get great experience, wisdom, industry connections and much more. These relationships can last you a very long time.
- Low Risk – If your business fails, you’re not required to pay back investments.
Cons of equity financing
- Time-consuming-It takes a long time, especially when compared to some of the fastest debt financing options out there.
- Sharing control of business- You’re giving away ownership of your business, and with that, decision-making power. You’ll have to consult with investors, and you might disagree over the direction of your company. You might even be forced to cash out and abandon your own business.
How to Choose Between Debt and Equity
The amount of money that is required to obtain capital from different sources, called the cost of capital, is crucial in determining a company’s optimal capital structure. Cost of capital is expressed either as a percentage or as a dollar amount, depending on the context.
The cost of debt capital is represented by the interest rate required by the lender. A $100,000 loan with an interest rate of six percent has a cost of capital of six percent, and a total cost of capital of $6,000. However, because payments on debt are tax-deductible, many costs of debt calculations take into account the corporate tax rate.
Assuming the tax rate is 30 percent, the above loan would have an after-tax cost of capital of 6% * (1 – 0.3), or 4.2%.
The cost of equity financing requires a more complicated calculation, called the capital asset pricing model, or CAPM. This calculation is based on the stock market’s risk-related rate of return and the risk-free rate, as well as the stock’s beta value. By taking into account the returns generated by the larger market, as well as the individual stock’s relative performance (represented by beta), the cost of equity calculation reflects the percentage of each invested dollar that shareholders expect in returns.
Finding the mix of debt and equity financing that yields the best funding at the lowest cost is a basic tenet of any prudent business strategy. To compare different capital structures, corporate accountants use a formula called the weighted average cost of capital, or WACC.
The WACC multiplies the percentage costs of debt – after accounting for the corporate tax rate – and equity under each proposed financing plan by a weight equal to the proportion of total capital represented by each capital type.
This allows businesses to determine which levels of debt and equity financing are most cost-effective.
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