Given the company’s financing, “value” is the measurable cost of obtaining capital. Debt is interest expense a company pays on its debt. Of capital cost of capital refers to the claim about earnings submitted to the shareholders for their share of the business.
What Is Debt Financing?
When a firm raises money for capital by selling debt instruments to investors, this is known as debt financing. In exchange for credit the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be paid on a regular basis.
What Is Equity Financing?
Equity financing is the process of raising capital through the sale of shares of the company. Equity funding is share of ownership for the shareholders. Equity financing can range from several thousand dollars raised by an entrepreneur from a private investor in an initial public offering (IPO) on the stock exchange in the billions.
To reduce the cost of financing the debt compared to capital
Granted, the company expected to perform well, debt financing usually can be obtained at the more economical.
For example, if you run a small business and need $ 40,000, you can get a Bank loan 40,000 $by 10 percent, or you can sell a 25% stake in his business in your neighbor for $40,000.
Suppose your business makes a profit of 20,000 $for the next year. If you took out a Bank loan, your interest expense (cost of debt financing) will be $4,000, leaving you with $16,000 in profit.
Conversely, if you used equity financing, you would have zero debt (and consequently no interest expense), but would keep only 75% of your profit (the other 25 percent is owned by your neighbor). Therefore, your personal profit will be only 15 000$, or (75% x $20,000).
From this example you can see how it is less expensive for you as the original shareholder of Your company, to issue debt, in contrast to the capital. Taxes make the situation even better if you had debt, since interest expenses are deducted from income before paying income tax, thus, acts as a tax shield (although we have ignored in this example, the taxes for simplicity).
Of course, the advantage of a fixed interest nature of debt can also be a disadvantage. It is a fixed expense, thus increasing the risk of the company. Returning to our example, suppose your company has just earned $5,000 in the next year. With the involvement of credit, you will still have the same $4,000 of interest to pay, so you’ll be left with only a $1,000 profit (a $ 5,000 – $4,000). With stocks, you again, no interest expense, but only keep 75% of their profits, thus leaving you with $3,750 profit (75% x $5,000).
However, if the company cannot generate enough cash, the fixed-cost nature of debt can prove too burdensome. This basic idea represents the risk associated with debt financing.
Never fully confident that their earnings will be in the future (although they can make reasonable estimates). More uncertain future income, represented the greater the risk. As a consequence, companies in very stable industries with consistent cash flows, as a rule, more intensive use of debt than companies in risky industries or companies who are very small and just beginning operations. New businesses with high uncertainty may have a difficult time obtaining debt financing, and often Finance their operations mainly through equity capital.
(For more on cost of capital, in the section “investors need good FCS.”)