Any company, whether public or private, requires funds to expand and carry out its operation. There can be many ways to raise funds like public deposits, IPOs and FPOs, borrowing secured or unsecured loans and many more but the prominent ones are Debt financing and Equity financing, which form a significant portion of the optimal capital structure.
Typically, businesses can choose between equity and debt funding. The decision frequently comes down to the company’s ability to acquire capital, its cash flow, and how vital it is to the company’s major shareholders to preserve control of the business. The debt-to-equity ratio demonstrates how equally debt and equity contribute to a company’s funding and assist a company to design its optimal capital structure.
A company needs to balance debt and equity properly as “Excess of everything is bad”. Higher debt increases the risk of losses on the company while higher equity may result in lower returns to the shareholders and high dilution of control. Through this article, we have explained what is more important in an optimal capital structure: Debt or Equity?
Selling a significant portion of a company’s stock to raise money is known as equity financing. For instance, Company ABC’s owner could need to raise money to finance company growth. The business’s owner chooses to sell a 10% stake in the firm to an investor in exchange for funding. With a 10% stake in the company’s stock currently, the investor will have a voting right in future business choices.
The fact that there is no requirement to repay the money obtained through equity financing is its major benefit in the optimal capital structure. The owners of a company naturally want it to be successful and provide equity investors with a beneficial return on their investment, but without having to make payments or pay interest, as with debt financing.
The corporation incurs no additional costs as a result of equity financing. With equity financing, there are no obligatory monthly payments, giving the corporation more money to go toward expanding the business. However, this does not imply that equity financing is without drawbacks, but it can be overcome by designing an optimal capital structure.
In actuality, the drawback is considerable. You will need to provide the investor with a portion of your business in exchange for money. Every time you make choices that will have an impact on the firm, you will have to confer with your new partners and split the earnings. The only option to get rid of investors is to buy them out, which will probably cost more than the money they provided you initially another way can be by designing an optimal capital structure which has a balance of Equity and Debt.
In debt financing, money for the capital is borrowed and then repaid in future with interest. A loan is the most typical type of debt financing in an optimal capital structure. Sometimes a company’s ability to operate is constrained by debt finance, which may prevent it from capturing opportunities outside of its core business.
Creditors look favourably upon a low debt-to-equity ratio, which benefits the company should it ever need to get further debt financing.
There are several benefits to debt finance. First of all, the lender has no power over your business. Once you have settled the obligation, your relationship with the financier is over. Additionally, the interest you pay is tax deductible. Finally, because loan payments are constant, expenditures are simple to predict. Thus, debt financing holds an important position in a company’s optimal capital structure.
It costs money to borrow from a lender. In addition to the money you borrowed from the lender, you’ll also have to pay interest. If you don’t have enough cash flow, you run the danger of not being able to make your debt payments on time. If you don’t pay back your loan, you might incur significant penalties or lose some valuable possessions. You could find it more difficult to obtain a loan from conventional financial institutions like a commercial bank. This is due to the fact that banks sometimes have stringent qualifying requirements for firms seeking finance.
Why is it costly to have too much equity?
Since equity investors take on greater risk when buying a company’s stock rather than its bond, the cost of equity is often higher than the cost of debt. Due to the higher level of risk involved in investing in stocks, an equity investor would thus expect higher returns (known as an “Equity Risk Premium”) than a comparable bond investor.
Due to a variety of reasons, investment in stocks is riskier than investing in bonds:
- Volatility of return
- No control over assets in case of default
- No guaranteed capital gains
- No legal obligation to give dividends
Why is it costly to have too much debt?
Due to the factors indicated above, the cost of debt is often lower than the cost of equity; nevertheless, if the debt is taken on excessively, it will become more expensive than equity. This is so because the loan interest rate has a major impact on the cost of debt (in the case of issuing bonds, the bond coupon rate) and it spotlights the need to design optimal capital structure.
The likelihood of a corporation defaulting on its debt rises as it takes on more debt. This is so because carrying greater debt results in higher interest costs. A company may enter default if it has a period of weak sales and is unable to produce enough cash to pay its bonds. Consequently, debt investors will expect a larger return from corporations with high debt levels, in order to get compensation for the additional risk that they are undertaking.
Why would a business opt for debt over equity financing?
If a corporation doesn’t want to give up any ownership of the business, debt financing would be preferred over equity financing. If a business has confidence in its finances, it would not wish to pass on the earnings to shareholders by giving someone else shares. Also, it is believed by many finance experts that debt is cheaper in the long run and also gives tax benefits.
Moreover, a lender of money won’t exercise his control over the management of the company. Thus, designing an optimal capital structure by carefully analysing the equity and debt requirement always contributes to the growth of the company.
Businesses can obtain the capital they want through stock and debt finance. Depending on your company objectives, risk tolerance, and control requirements, you’ll need one. Many firms in the startup stage will explore equity funding, whilst established businesses and those with good credit who don’t mind taking on debt may choose typical debt financing options like small business loans.
Since startups had relatively few assets to utilise as a security with the lenders, we would always cite them as an example when you asked for one. They lack experience, are not lucrative, and have negative cash flow. Debt financing becomes quite hazardous as a result. It is where equity financing steps in as investors can bear the risk, for they are looking forward to huge returns if the company succeeds.
To ensure that your business produces the proper profits, it is crucial to maintain a balance between a company’s debt and equity ratios. Too much equity can weaken the current owners, which can impair the profits, while too much debt might result in bankruptcy. Therefore, the secret to maintaining the company’s capital structure is finding a balance between the two by forming an optimal capital structure.
As we are all aware, it is crucial to preserve and retain everything in its proper balance. Maintaining a proper balance between funding your business might result in a profitable outcome. The same holds true for investments and businesses.
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Frequently Asked Questions (FAQs)
Q1. What all comes under Debts?
Ans. Debts consist of various loans and advances like debentures, bank loans, government-subsidized loans, etc. It can be short-term, medium-term or long-term.
Q2. Do creditors of any business have ownership of the property or assets of the organization?
Ans. No, creditors of the business do not have any ownership rights on the assets of the organization. Ownership right like voting rights is only enjoyed by equity shareholders.
Q3. How should you decide whether you should opt for Equity Financing or Debt Financing?
Ans. There are many financial and accounting ratios like debt-to-equity ratios, current ratios, liquid ratios and many more which are considered while deciding the optimal capital structure for any organization.