I've been asked about why cost of debt is cheaper than cost of equity financing; pros and cons of debt financing and equity financing and when to use which for three times already, but I cannot really organize my answer in a structured way. Any thought on how to answer these questions?
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Explain that because equity is last in the priority of claims and is generally a riskier investment, and as such investors require a higher return to be compensated for taking that risk. Thus the cost of equity is higher than the cost to issue debt.
The major pro of issuing debt is that it is cheaper, and non dilutive to the existing equity ownership in the business The major con is that debt is a fixed cost, and no matter what happens you have to service that debt
The major pro of equity is that it does not create a fixed cost for the business in the future The major con of equity is that it dilutes the existing ownership of the business
When to use each depends on a variety of factors, and each company is different. I'll list a few major ones below.
Probably most importantly, what is there a market for at the moment. If a company is a "hot" IPO like Snapchat or if Uber went public, then there are a ton of investors out there just dying for a piece of equity in that business, so there might be significant appetite in the equity market for them to raise equity capital. Some companies may be less than stellar, and maybe there is no market for them to issue equity in because they are seen as incredibly risky, so maybe they need to issue debt to fund their business because investors want some sort of claim on the business in the event things go wrong, and this varies within debt like from investment grade debt to high yield.
Each company has an optimal capital structure within the WACC where issuing more debt (remember that it is cheaper to issue than equity) will reduce the WACC, and therefore the discount rate of the company (higher valuation) until a certain point where there is too much debt in the capital structure, and the Cost of Debt begins to increase as well as the Cost of Equity because of how risky it is becoming.
Whatever the market is doing at the time. In a low interest rate environment, it becomes cheaper to issue debt and this can be more attractive, whereas maybe the equity market is not as active. Or the equity market could be very active, and companies want to access that form instead in order to keep their capital structures limber.
Adding on your comments, is the company's ability to pay back the debt (i.e ability to generate stable cash flow) also a point worth talking about in the answer?
Sure, companies and industries vary in how much debt they can support due to their stability of cash flows. For example, a cyclical business may not have stable enough cash flow to support a huge debt load, but a company like AT&T has very stable cash flows and can support a huge debt load. I believe if this AT&T Time Warner deal goes through, AT&T will become the most heavily indebted company out there. So part of their decision to take on so much debt has been their confidence in the stability of their cash flows.
That might be a good example to reference during an interview, as that is relating a current event to the question.
Thx so much!!
Debt vs Equity (Originally Posted: 06/12/2013)
Hi guys,
In terms of RE career aspects, what do you find more interesting/rewarding/useful for owning properties in future. Why debt? Why Equity? Pros/Cons of the job would also be appreciated. They say the grass is always greener... Which side are you on?? Let the disputes begin!
interested as well
What are you asking exactly? Working in a firm that buys debt vs one that buys the actual property?
Depends on the type of debt. Direct equity investment (having controlling interest not just a jv or pref partner) is generally viewed as more entrepreneurial (devising business plans for not acquisition/development, capital structure, leasing/operation/marketing of property), but some forms of more creative opportunistic opportunistic debt have highly entrepreneurial elements to it as well.
The difference just comes down to limits on upside and downside - where secured debt is capped on both and equity isn't.
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