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.

Outlines

00:00

💼 Understanding Debt and Equity Financing

The script introduces the concepts of debt and equity financing. Equity financing involves selling a portion of a company's ownership to raise capital, as illustrated by the example of company XY Jet selling 10% ownership for capital. Debt financing, on the other hand, is the process of borrowing money, which the company must repay with interest. The script uses a hypothetical scenario of a small business needing $40,000 financing to compare the two methods. With debt financing, the business would pay $4,000 in interest on a $40,000 loan, leaving $16,000 in profit. In contrast, equity financing would result in no interest but the original owner would only keep 75% of the profit, resulting in a personal profit of $15,000. The script also discusses the impact of taxes, where interest payments can act as a tax shield, and the risks associated with fixed interest payments, especially if the company's profits are low.

05:02

💸 When Debt Financing is Cheaper Than Equity

This paragraph delves into why debt financing is generally cheaper than equity financing, primarily due to the tax benefits of interest payments. However, it also explains that the cost of debt can rise if a company takes on too much debt, increasing the risk of default and leading to higher interest rates demanded by debt investors. The paragraph contrasts this with equity financing, which is riskier for investors and thus typically commands higher returns. It highlights that both too much debt and too much equity financing can be expensive. The cost of equity is generally higher than debt because equity investors face more risk, including market volatility, lower priority in asset claims, and the uncertainty of dividends and capital gains.

Keywords

💡Equity Financing

Equity financing is the process of raising capital by selling a portion of a company's ownership or equity. In the video, this is exemplified by the owner of company XY Jet selling 10 percent of ownership to an investor for capital. This concept is central to the video's theme of explaining different financing methods, as it directly impacts a company's ownership structure and the rights of the investors involved.

💡Debt Financing

Debt financing refers to raising money by borrowing, which the company must repay along with interest. The video uses the example of a small business owner considering a $40,000 bank loan at a 10% interest rate to illustrate this concept. Debt financing is a key component of the video's exploration of financing options, as it contrasts with equity financing in terms of risk and cost.

💡Interest Expense

Interest expense is the cost of borrowing money, which must be paid periodically, typically annually or semi-annually. In the script, it's calculated as 10% of the $40,000 loan, amounting to $4,000. This concept is crucial for understanding the fixed costs associated with debt financing and how they can affect a company's profitability.

💡Profit

Profit in the context of the video represents the earnings of a business after all expenses, including interest if applicable, have been deducted. The video uses a scenario where the business earns $20,000 to demonstrate how profit is affected by the choice between debt and equity financing. Profit is a central theme as it directly relates to the financial health and performance of a company.

💡Tax Shield

A tax shield refers to the reduction in taxable income that results from deductible expenses, such as interest on debt. The video mentions that interest expenses are deductible from earnings before income taxes, thus acting as a tax shield. This concept is important as it highlights one of the potential benefits of debt financing over equity financing.

💡Risk

Risk in the video pertains to the potential for financial loss or failure to meet obligations, particularly in the context of debt financing. The script explains that taking on too much debt can increase the risk of default, which in turn raises the cost of debt. Risk is a fundamental concept in the video, as it influences a company's financing decisions.

💡Equity Risk Premium

The equity risk premium is the additional return investors demand for investing in stocks over safer investments like bonds. The video explains that equity investors take on more risk and therefore demand higher returns. This concept is important for understanding why equity financing can be more expensive than debt financing.

💡Volatility

Volatility in the video refers to the variability of returns, particularly in the stock market compared to the bond market. It's mentioned as one of the reasons why investing in stocks is riskier, as stock returns can fluctuate more than bond returns. Volatility is a key concept when discussing the risks associated with equity financing.

💡Default

Default in the script means failing to meet financial obligations, such as not being able to pay back a loan or interest. The video uses default as an example of a risk associated with debt financing, explaining that if a company cannot generate enough cash to meet its debt obligations, it may default. Default is a critical concept as it illustrates the potential consequences of excessive debt.

💡Dividends

Dividends are payments made by a corporation to its shareholders, typically from profits. The video notes that dividends are discretionary, meaning a company is not legally obligated to issue them. This concept is important as it contrasts with the fixed nature of debt payments, highlighting another difference between equity and debt financing.

💡Capital

Capital in the video refers to the funds a company uses to finance its operations and expansion. It is mentioned in the context of equity financing, where an investor provides capital in exchange for ownership. Capital is a foundational concept as it represents the resource that financing methods aim to provide to a company.

Highlights

Equity financing involves selling a portion of a company's equity for capital.

Investors in equity financing gain partial ownership and a say in business decisions.

Debt financing is money raised by borrowing, representing an obligation to repay.

Debt financing is generally cheaper due to lower costs compared to equity and preference shares.

Funds raised through debt financing must be repaid after a specific term.

A real-world example compares taking a bank loan versus selling equity in a business.

Interest expenses on debt reduce profits, but are fixed and can act as a tax shield.

Equity financing results in no debt or interest expense but reduces the owner's share of profits.

The example illustrates that debt can be less expensive than equity for the original shareholder.

Debt financing can increase risk due to fixed interest payments during low-profit periods.

Equity financing can be cheaper than debt financing, depending on the company's profitability.

Too much debt financing can be expensive as it raises the cost of debt above equity costs.

Higher debt increases the risk of default, leading to higher interest rates demanded by investors.

Too much equity financing is also expensive due to the higher risk and required returns for equity investors.

Equity investors demand higher returns due to the additional risks associated with stock investments.

Investing in stocks is riskier than bonds due to factors like market volatility and lower asset claims in case of default.

Dividends are discretionary, unlike interest payments on bonds, adding to the risk of equity investments.

Transcripts

at first let's know what are debt

financing and equity financing

then we'll see an example how to work in

real world

let's start with equity financing equity

financing involves selling a portion of

a company's equity

in return for capital for example the

owner of company

xy jet might need to raise capital to

fund business expansion

the owner decides to give up 10 percent

of ownership in the company

and sell it to an investor in return for

capital

that investor now owns 10 percent of the

company and has a voice

in all business decisions going forward

now let's know what is debt financing

money raised by the company in the form

of borrowed capital

is known as debt financing it represents

that the company owes money towards

another person or entity

they are the cheapest source of finance

as their cost of capital is lower than

the cost of equity and preference shares

funds raised through debt financing are

to be repaid after the expiry of the

specific term

we have known water debt financing and

equity financing now we should know

that how they work in real world now

let's see

an example

suppose you run a small business and

you need 40 000 usd of financing

you can either take out a 40 000 bank

loan

at a 10 interest rate or

you can sell a 25 stake in your business

to your neighbor for 40 000

suppose your business earns a 20 000

profit during the next year

if you took the bank loan your interest

expense

would be four thousand leaving you with

sixteen thousand in profit here don't

make mistake

do not think that

you will cut ten percent on your twenty

percent twenty thousand

profit now you have to cut that in

person

on the 40 000 that you took loan from

the bank

so 10 percent of 40 000

is 4 000 now you have to deduct this 4

000

from your 20 000 profit leaving you 16

000 in your hand

conversely had you used equity financing

you would have zero debt and as a result

no

interest expense but would keep you

only 75 percent of your profit because

the other 25 percent being owned by your

neighbor

a shareholder therefore

your personal profit would be 15 000

which is 75 percent of 20 000

and your 5000 would be yours in your

shareholders hand

from this example you can see how it is

less expensive for you

as the original shareholder of your

company to issue

debt as opposed to equity taxes make the

situation even better

if you had a debt since interest

expenses deducted from earning before

income taxes early fight

thus acting as a tax shield although we

have ignored taxes in the example for

the sake of simplicity

of course the advantage of the fixed

interest nature of date can also be

an in disadvantage it presents a fixed

expense thus

increasing a company's risk going back

to our example

suppose your company only earned 5000

during the next

year instead of 20 000. with debt

financing

you still have the same 4000 of interest

to pay

this amount is fixed so you would have

uh

just 1000 in your hand right because you

have to give that 4 000

interest right that's your expense so

you're having

1 000 in your hand from that 5 000

profit

with equity you again have no interest

expense

but this time you can only keep 75

percent right

so every time you can keep 75 percent

from the profit

no matter how much the profit is now if

you keep 75 percent profit

this will leave you with three thousand

seven hundred and fifty

dollar right so five thousand seventy

five thousand of five thousand

is seventy five percent of five thousand

is three thousand seven hundred and

fifty

dollar here we can see that debt

financing

is more expensive that than equity

financing now

however if a company fails to generate

enough cash the fixed cost nature of

debt can prove to burdensome

okay the basic idea represents the risk

associated with debt financing

now the question is which is cheaper

debt or equity

that is cheaper than equity for several

reasons

this the the primary reason for this is

however

that uh debt comes without tax this

simply means that

when we choose debt financing it lowers

our income tax

because it helps remove the interest

acquirable on the date

on the earning before interest tax

but if we look back our last example

why we saw that equity financing

is cheaper than debt financing

so we can say that it depends

sometimes equity financing

can be even cheaper than debt financing

but maximum time in general date

financing is cheaper than equity

financing

you have to remember that too much debt

financing and too much equity financing

both

can be expensive

so let's see how much

debt financing can be expensive

while the cost of debt is usually lower

than the cost of equity

for the reasons mentioned above

taking on too much debt will cause the

cost of debt to rise above the cost of

equity

this is because the biggest factor

influencing the cost of debt

is the loan interest rate in the case of

issuing bonds

or the bond a bond coupon rate

as a business as a business takes

on more and more date its probability of

defaulting on a state

increases this is because more debt

equals higher interest payments

if a business experiences a slow sales

period and cannot generate sufficient

cash to pay its bondholders

it may go into default therefore debt

investors will demand a higher return

from companies with a lot of debt in

order to compensate them for the

additional risk they are taking on

this higher required return manifests

itself in the form of higher interest

rate

now that we have understood why too much

debt financing is

expensive let's know why too much equity

financing is

also expensive the cost of equity is

generally higher than the cost of debt

since equity investors take

take on more rigs when purchasing a

company stock as opposed to a company's

bond

therefore an equity investor will demand

higher returns

an equity risk premium then the

equivalent bond investor to compensate

him or her for the additional risk that

he or she is taking on

when purchasing stock investing in

stocks is riskier than investing in

bonds because of a number of factors for

example

the stock market has a higher volatility

of returns than the bond market

stockholders have a lower claim on

company assets in case of company

default

capital gains are not a guarantee

dividends are decretionary for example a

company has no legal obligations to

issue dividends