The cost a company must pay to raise funds depends on wise financing decisions with lowest feasible cost of capital. Most companies may opt for debt or equity financing depending on the budget estimates, type of funding desired, funding source and specific funding timing. Debt financing means any money borrowed from lenders repayable with interest over a specified time but equity financing means any funding e.g. money lent in an exchange of ownership and control of the company.
Most notable advantage of debt financing is that money comes as loan from investors who don’t claim ownership and control of the company, they are only obliged to the repayment of the principal of the loan plus accrued interest ending the relationship when the total amount is paid back as opposed to equity financing where the more investors involved the more loss of control due to dilution of ownership. Debt financing helps to retain profit since only the loan is serviced as a monthly fixed expense as oppose to equity where every profit must be shared with equity holders so the more profit is made the more money given to investors. Debt financing lowers tax liability as the interest is tax deductable based on prime interest rate but with equity finance, the dividend paid is not tax deductable as they come in after-tax income.
Debt financing has its disadvantages such as limiting the flow of the cash as the company regularly pays for the principal of the loan plus accrued interest and high interest rate may increase the risk of insolvency as highly leveraged companies may not grow due to cost of loan repayment unlike equity financing where funds are obtained without incurring debts thereby encouraging cash flow which can be used for follow-on investments. Other disadvantages of debt financing are; the company’s inability to pay back the loan may tarnish the credit worthiness of the company hindering the chances of borrowing additional capital after facing loan defaulting penalties such as paying extra late repayment fees and possession of collateral .This favors equity financing where there is no repayment of contribution, no single asset of the company to be used as collateral and incase of bankruptcy personal funds are not touched. Debt financing has restrictions on the amount of loan to be given and restricted to companies with sound financial success hence need for other financing sources to start-up companies.
Debt financing is suitable for well established companies with solid collateral, positively progressing sales and good profit margin on the other hand, equity financing works well for conventionally managed companies with high profit returns and poor credit ratings among other factors.
Resources
Simply Finance. (Com.2010).Pros and Cons of Debt and Equity Finance, retrieved from http://www.simplyfinance.co.uk/articles/pros_cons_of_debt_financing.html
Tripoli-ghibli blogspot.com. Debt Equity Finance, Commercial Finance-Debt Vs Equity Financing, retrieved from http://tripoli-ghibli.blogspot.com/
