Debt Financing vs Equity Financing | Real Life Examples |

Summary

This script explains the concepts of debt and equity financing, using a small business needing $40,000 as an example. Debt financing involves taking a loan with interest, while equity financing means selling a part of the business. The example illustrates how debt can be cheaper due to tax benefits but comes with fixed costs and higher risk if profits are low. Conversely, equity financing results in sharing profits but has no fixed costs. The script also highlights that too much of either financing can be costly, emphasizing the balance needed in financial strategy.

Takeaways

• 💼 Equity Financing: Involves selling a portion of a company's equity in return for capital, giving up ownership and decision-making rights.
• 💰 Debt Financing: Money raised by borrowing, representing an obligation to repay, with funds to be repaid after a specific term.
• 📈 Cost Comparison: Debt financing is generally cheaper than equity financing due to lower costs of capital.
• 🔑 Real-world Example: A business can choose between a bank loan or selling equity, affecting profit distribution and financial risk.
• 📉 Interest Expense: With debt financing, interest is a fixed cost, reducing profit but potentially offering tax benefits.
• 🏦 Tax Shield: Interest expenses are deductible from earnings before taxes, acting as a tax shield.
• 📊 Profit Impact: Debt financing can reduce personal profit due to interest payments, while equity financing reduces profit share.
• 📈 Risk of Debt: High levels of debt can increase the cost of financing as the risk of default rises.
• 📉 Risk of Equity: Too much equity financing can be expensive due to the higher returns demanded by equity investors for the risk.
• 💹 Market Volatility: Stocks are riskier than bonds due to factors like higher volatility and no guaranteed returns.

Q & A

What is equity financing?

Equity financing involves selling a portion of a company's equity in return for capital. For instance, the owner of Company XY Jet might sell 10% of ownership to an investor for capital, giving the investor a say in business decisions.

How does debt financing differ from equity financing?

Debt financing is money raised by borrowing, which the company owes to another entity. It's typically cheaper than equity financing because its cost of capital is lower. Funds raised through debt financing must be repaid after a specific term.

What are the implications of selling equity for a business owner?

Selling equity means giving up a portion of ownership and decision-making power. For example, if a business owner sells 25% of their business for $40,000, they would keep 75% of the profits but would also share 25% with the investor.

Why might a company choose debt financing over equity financing?

A company might choose debt financing because it's generally cheaper and doesn't require giving up ownership. Additionally, interest paid on debt is tax-deductible, acting as a tax shield.

How does the interest expense from debt financing affect a company's profit?

The interest expense reduces a company's profit. For example, if a company earns $20,000 and has a $4,000 interest expense, its net profit would be $16,000.

What is the risk associated with debt financing?

The risk with debt financing is that fixed interest payments must be made regardless of profit. If a company's earnings are low, it could struggle to meet these obligations, potentially leading to default.

Why might equity financing be considered cheaper than debt financing in some cases?

Equity financing might be cheaper if a company's profits are high enough to cover the share of profits given to investors without the burden of fixed interest payments.

How does the cost of debt financing change with the amount of debt a company takes on?

As a company takes on more debt, the cost of debt can rise above the cost of equity because investors demand higher returns to compensate for the increased risk of default.

Why is too much equity financing expensive for a company?

Too much equity financing is expensive because equity investors demand higher returns due to the higher risk associated with stocks compared to bonds. This results in a higher cost of capital for the company.

What are the tax implications of debt financing?

Debt financing can lower a company's income tax because interest payments are tax-deductible. This reduces the taxable income, which can be beneficial for the company.

How does the volatility of the stock market affect the cost of equity financing?

The stock market's higher volatility compared to the bond market means equity investors demand a higher risk premium, increasing the cost of equity financing.