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20 Sep, 2024
6 mins read
Capital is a constant necessity to fuel a company's growth. Businesses generally turn to two primary sources for these funds: debt or equity. Similarly, investors face a fundamental choice between these asset classes, guided by their risk and return expectations. Understanding the nuances of debt and equity capital is crucial for companies and investors. Read on to learn more about the meaning, advantages, and examples of how debt vs. equity works.
Debt refers to money companies borrow to fund their sustainability and growth plans. It must be repaid over time with interest. Debt can be bank loans, bonds, or other financial instruments.
The key advantage of debt for companies is that they can raise funds without giving up ownership or control. However, the company must make regular interest payments and repay the principal. Any default in meeting these obligations can result in penalty and legal liability.
Equity, on the other hand, is about ownership in the company. A public or private company raises capital by issuing shares to investors who become part owners.
Equity financing does not require regular payouts to shareholders. Instead, they are entitled to share in profits in the form of dividends, which are distributed according to the guidelines of the Companies Act 2013.
Equity investments allow investors to participate in a company’s success through dividends and capital gains if the value of their shares increases.
However, equity is riskier than debt because if the company performs poorly, shareholders may not see returns and will be last to recover their money in case of bankruptcy.
Debt offers several advantages over equity for investors and companies, making it a suitable option with limited risk and stable returns. The benefits of debt over equity are-
Debt allows companies to leverage their operations. Access to borrowed funds will enable companies to undertake larger projects or expansions than they could with equity alone. This can be a crucial factor in scaling operations quickly in a competitive market.
Debt is often cheaper than equity for companies as interest payments on debt are tax-deductible, reducing the company’s taxable income. In contrast, dividends paid to shareholders are not tax-deductible, making equity more expensive.
Debt comes with a fixed repayment schedule, which can be easier to plan for. The company knows exactly how much it needs to pay and when. This predictability helps manage cash flow and budgeting. On the other hand, equity does not require repayment, but shareholders expect dividends, which can be more uncertain and flexible.
A company that effectively uses debt can enhance its Return on Equity (ROE). Debt can finance growth without requiring additional equity, potentially leading to higher profits per share for existing shareholders. However, this works best when the company generates returns higher than the cost of debt.
When a company takes on debt, it does not have to relinquish ownership or control. Unlike issuing new equity, which dilutes existing shareholders' ownership, debt allows founders and existing shareholders to maintain their stake in the company. This is particularly important for entrepreneurs who want to retain control over their business.
While debt can be a helpful tool for financing growth, it comes with significant disadvantages compared to equity. Some of these disadvantages are explained here,
Debt increases financial risk for companies. Unlike equity, which does not require repayment, debt comes with fixed interest and principal payments that must be made regardless of the company’s financial situation. Failure to meet debt obligations can lead to cash flow problems or bankruptcy.
Companies with significant debt have a higher burden on their cash flow. Interest payments are mandatory and regular, reducing the cash available for other operational needs or investments. This can lead to significant financial strain, especially for companies with irregular income streams or those in highly competitive markets.
Taking on too much debt can limit a company's ability to borrow more in the future. Lenders may see a highly leveraged company as a higher risk and either refuse additional loans or offer them at higher interest rates. This can restrict the company’s ability to grow or respond to opportunities and challenges.
High levels of debt can negatively impact shareholder returns. If interest payments consume the company’s profits, fewer funds may be available for dividends or reinvestment into the business. This can reduce the attractiveness of the company’s shares to investors, potentially lowering the share price.
Here’s an example of how a company can make use of debt or equity for financing
Consider a tech startup in Bangalore looking to expand quickly and needs Rs. 50 crore to scale its operations, hire more staff, and market its product. The startup has two finance options: debt or equity.
The startup could approach a bank for a Rs 50 crore loan. The bank agrees to offer a loan with an interest rate of 10% per year. The startup would need to make regular payments to the bank to cover the interest and eventually repay the Rs 50 crore.
If the business does well, the profits generated by the expansion could easily cover these payments. However, if the company faces unexpected challenges, it might struggle to make the payments, leading to financial stress or even bankruptcy.
Alternatively, the startup could raise Rs.50 crore by selling shares to investors. This means giving up a portion of ownership in the company. If the startup is valued at Rs. 200 crore, selling 25% of the company to investors would raise Rs. 50 crore needed.
The advantage is that the company doesn’t have to repay the money or pay interest. However, the founders now own less of the company, and the new investors will have a say in how the company is run.
If the company becomes very successful, the founders’ reduced ownership stake could mean they make less money in the long run than if they had taken on debt and retained full ownership.
Debt and equity are companies' primary sources of funds and fundamental investment options in any investment portfolio. Every type of asset has its pros and cons for businesses and investors. Deciding which one to choose depends on various personal and outside factors, including the company's financial health, potential for growth, and the investor's comfort with risk.
Understanding these options helps companies make informed financial decisions and allows investors to align their investments with their financial goals
Debt is often considered safer due to its fixed returns and lower risk, while equity offers higher potential returns but with greater risk and volatility. The choice depends on an investor’s risk tolerance and return expectations.
Debt is generally cheaper than equity because it usually costs less and provides tax benefits through deductible interest payments.
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