Debt Financing vs Equity Financing | Real Life Examples |
Summary
TLDRThis 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
💼 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.
💸 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.
Mindmap
Keywords
💡Equity Financing
💡Debt Financing
💡Interest Expense
💡Profit
💡Tax Shield
💡Risk
💡Equity Risk Premium
💡Volatility
💡Default
💡Dividends
💡Capital
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
浏览更多相关视频
Equity vs Debt Financing | Meaning, benefits & drawbacks, choosing the most suitable
Non SBA Deal Financing
Project 1, Linda, financplan
Introduction to bonds | Stocks and bonds | Finance & Capital Markets | Khan Academy
24. Detailed Information On Debentures from Financial Management Subject
Financial Management: Financial Forecasting
5.0 / 5 (0 votes)