Businessfunding: Debt vs Equity

Investopedia.com defines financing as” the act of providing funds for business activities, making purchases or investing.” There are two common financing options used by businesses. The first is debt and the other is equity. According to Damodaran (n.d.), debt is when you promise to make fixed payments in the future. On the other hand, equity financing is defined as the process of raising capital through the sale of shares in an enterprise (Financing, n.d.). This is commonly done by issuing stocks.

Both options have their own advantages and disadvantages. First, debt financing is tax deductible. The interest paid on the loan is tax deductible whereas the cash flows from equity are generally not (Damodaran, n.d). Secondly, debt financing brings added discipline to the business. Borrowing money may force managers to think about consequences and avoid bad investments (Damodaran, n.d.). The lender does not have control or any ownership in the company. On the other hand, equity does not have a fixed maturity and is the lowest priority in financial trouble. Managers have control over the investments and the shareholders have ownership in the company.

For a business, the choice of debt or equity financing is based on many factors, such as size of the company, state and dynamics of the industry, perspectives of the company, debt-to-equity ratio, debt servicing costs, cost of equity, and cost of capital. Debt financing is safer for investors, while equity financing is more risky for investors, but at the same time safer for the company (Grossman & Livingstone, 2009). Since debt financing creates contractual obligations, companies need to carefully consider their ability to repay the debts. Debt servicing incurs higher costs than equity financing, and if the company experiences fast growth, it might suffer from high debt servicing expenses. It has also been shown that companies with consistent profit operating in low-risk and slowly growing industries more...