Debt vs Equity Financing
These are two ways companies and firms can finance projects, buildings, equipment, investing, etc.
What Are Debt And Equity Financing?
Debt and equity financing are two ways companies and firms can finance projects, buildings, equipment, investing, etc. Debt financing is when companies borrow money in terms of bonds, bills, or notes. Equity financing is when they issue equity for a specific price.
Companies need money to operate and grow; however, sometimes, they need immediate funds or resources to expand as they wish. Luckily, they can use a combination of debt and equity tools to finance said projects and activities. Both forms of financing have different benefits.
Businesses will choose between the two options based on how willing they are to give up ownership to those willing to invest in the company. They will also look at the amount of cash flow they have during a period to determine if they want to take on debt for new activities.
Debt financing is when companies issue investment tools that give investors returns. The debt instruments can be sold to individual investors or large financial institutions. When the debt has matured, investors are promised their principal returned and interest earned.
Issuing debt can be in the form of bonds, bills, or notes. For example, an investor may buy some corporate bonds with 5% interest to earn. When the bond matures, they will receive their principal and 5% interest earned. This is the opposite of equity financing.
Companies will issue equity to investors as another way of financing projects and activities. This is usually done through corporations going public on the stock exchanges. In addition, corporations will sell shares to investors, which can be used for short and long-term financing.
Start-up companies will go through several phases of equity financing as it progresses into a mature and successful company. Also, as companies decide to go public, state and federal governments will closely monitor them to ensure they are following regulations.
Debt Financing
Debt financing is a great way for companies to borrow capital from other investors or institutions willing to lend their money. For example, companies that need money for projects and activities may reach out to banks, financial institutions, or retail investors to borrow money.
Corporations can borrow money through a few different avenues. Some financing options include bonds, bills, notes, and the most commonly used loans. Loans are taken when a company goes directly to the bank and asks for more money to operate.
Businesses borrow money all the time, depending on the company's structure. When they get paid for their products or services, they may have to take out loans before they are paid. Companies that make most of their purchases rely on loans to pay their bills.
A company with a good relationship and reputation with a bank will likely go straight to the bank to take a loan if needed. In addition, most corporations will deal with the same banks over time. This helps create a good relationship and allows for trust to be built.
Companies can sell corporate bonds, many of which have short maturity dates. Time to maturity can range from one to four years in length. Bonds with long maturity dates usually have higher rates of return; however, they entail more risk.
Companies should consider all forms of financing to find which option is the cheapest. For example, they should look at whether they will have to pay more interest to a bank or an investor or institution that has invested money with them expecting a return of capital.
After all, every bank and institution that buys debt from companies are investor, at least temporarily. Buying debt is one way to look at debt financing from an investor's perspective. You buy debt from a company in hopes they will return your money and more.
All financing contributes to the cost of capital, including the amount of debt and equity financing it takes for a business to operate.
Example of Debt Financing
There are many situations when a company may use debt financing, and many situations result from a company trying to expand and grow. Other entities that issue debt financing are governments or other entities, such as issuing municipal bonds to build a school.
Suppose a company is trying to fund a project of opening a new office in a different city. Oddly, the corporation either does not have the capital to make a move on its own, or it is more beneficial to use capital elsewhere and borrow the funds to move over.
The company can reach out to an investment bank, they will help the business create bonds or other fixed-income securities to sell to investors or institutions. The corporation can reach out to their bank to see if they qualify for a loan.
If the financial team manages the situation well, they will weigh the pros and cons and the risks and benefits of each option to choose better for their company.
Equity Financing
Equity financing is when a company offers common shares to the general public through a stock exchange. A company will do this when they have grown to a point where it may only be able to grow if it goes public. However, going public is a challenging task.
However, companies do not have to go public to sell equity in the company. To do this, companies will have to find willing investors. Corporations may use the capital they receive through the sale of shares to pay for short-term or long-term bills or projects.
In both cases, companies can go directly to an investment bank and get help from a team of bankers willing to help find investors. Investors will gain ownership and pay for the stock in the company. Many people can invest privately or publicly.
There are few limits as to who can participate in the investing of private or public companies. The range ranges from ordinary retail investors to large institutional investment firms. There is a large amount of risk for investors when buying equity.
When a company wishes to go public, it will work with an investment banking team that will help them reach its initial public offering (IPO) day. This is the day when a company is first released on the stock exchange. This is a very big deal for investors and the company.
Once a company has gone public, it will usually go through different stages of maturity, and it will attract different investors along the way. For example, venture capitalists may decide to invest in the beginning stages of a company.
However, because they are getting in very early, venture capital firms will usually bargain to get preferred shares over common ones. Preferred shares offer more benefits and protection in case of downside. Investors want the best and most protected equity they can get in a company.
Companies wishing to have an equity offering will either stay private and issue to willing investors or go public. Going public through an investment bank is tough, but they can come out with much more capital for needed expansion.
Example of Equity Financing
When a company needs capital to grow, expand, or pay short-term costs, it may decide to finance the operations through the sale of equity. Private and public companies can do this. The transition from private to public is thought of when companies wish to sell equity.
For example, suppose a private company, XYZ wants to build a new manufacturing plant to put their company on the map. However, they do not currently have liquid funds to push the project forward. Company XYZ can take its business to an investment bank and go public.
This company will work with an investment bank for over six to ten months. During this time, an investment banking team will help the company through the complex process of meeting many regulations. They will also find institutional investors willing to invest in the company.
Once the company reaches its IPO date, then they should have plenty of resources to meet its needs and goals to expand and grow much larger.
Advantages and Disadvantages of Debt and Equity Financing
There are many advantages to debt and equity financing, and companies should consider both options and decide what is best for them. Both options have factors that relate directly to how successful the financing will be.
Advantages of Equity Financing are:
- When financing through the sale of equity, there is no burden on the company to pay back a loan to the bank or credit union.
- A company does not have to worry about how good its creditworthiness is because they are not borrowing from anyone. Instead, it is just trading equity for a predetermined price.
- When you allow investors to take ownership of your company, certain investors may wish to gain a large number of shares to gain control. They can do this by being on the Board of Directors; this is an excellent opportunity to learn and grow.
Advantages of Debt Financing are:
- When you debt finance projects and activities, you do not have to give ownership to the loan lender, note, bill, or bond.
- There are tax advantages to taking out loans. For example, the amount you pay in loan interest can be considered a tax deduction.
- Finally, one can predict the amount of money they may receive from equity financing. However, in debt financing, you know exactly how much you have to pay and the amount of interest due.
Disadvantages of Equity Financing are:
- A company must perform well so investors can get a return on their investment. Conversely, investors may pull their money out if a corporation does not perform well.
- Also, a company can predict the amount of money it may receive from investors, but it cannot know the exact amount. This is the opposite of debt financing.
- When selling equity in a company, the owner will lose control of the company.
- Once an owner loses full control of their company, there may be a conflict between the executives on where the company's future is headed.
Disadvantages of Debt Financing are:
- Sometimes, a company cannot qualify for a loan, where they may be able to sell equity.
- Banks and other lenders of capital may need some sort of collateral before they are willing to lend to a company.
- Taking on debt means that companies will have fixed payments by certain dates. This means they must have the capital in hand to pay their lenders.
- When companies only use debt financing, they may take on too much. If this happens, they will not be cash flowing the amount they should.
Summary
Companies will come to a point where they will not be able to fund all the operations they wish to complete. There are many different ways a company can receive funding, but most boil down to debt and equity financing.
Debt financing is when a company is given a loan or issues bonds. Some of these bonds can be commercial paper. However, they will have to pay back the money. Equity financing is when a company sells equity to investors for a predetermined price.
Most companies have a strategy including debt and equity financing. They might use debt for long-term projects and activities and the sale of equity for the short term since they are not positive about how many investors they might have. Both options have different advantages.
For instance, debt financing is great because a company obtains the exact amount of money they need, and they know exactly when and how much they have to pay back to its lenders. On the other hand, equity financing allows companies to gain capital without constricting the cash flow.
In general, most financing options can either be considered debt or equity financing. These options are the best way for companies to gain capital for new projects and activities needed to grow their company.
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