Comparison of debt and equity financing PDF

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Comparison of debt and equity financing When we consider the way firms structure their operations it is necessary examine the essential difference between debt and equity finance. The capital structure used by the enterprise has implications for its operation and the presence of debt it that structure will affect returns to equity investors. Equity Equity is the basic risk capital of an enterprise. Every enterprise must have some equity capital that bears the risk to which it is inevitably exposed. The outstanding characteristic of equity capital is that it has no guaranteed or mandatory return that must be paid out in any event and no definite timetable for the repayment of the capital investment. (Thus, capital that can be withdrawn at the contributors option is not really equity capital and has instead the characteristics of debt.) Equity is significant from the point of view of an enterprises stability and to the risk of insolvency. It’s outstanding characteristic is that it is permanent, can be counted upon to remain invested in times of adversity and has no mandatory requirement for dividends. The flip side to this permanence is the need to reward all equity holders in a similar way through dividends for the life of the enterprise. Thus, if profits are made and paid out as dividends they are paid in equal proportion to all shareholders. Equity funds are those that can be most confidently committed to investment in long term assets and be exposed to greatest risk by owners. (Debt funds are technically ‘on call’ and in adverse times may be required to be repaid early by creditors. Often, specific conditions in loans may trigger repayment clauses, if for example the borrower exceeds certain gearing levels or misses repayment dates.) Short & Long term Debt. Both Short & Long term Debt, in contrast to equity, must be repaid within a specific time frame. The longer the term of the debt and the less onerous its repayment provisions, the easier it will be for the enterprise to service it. Nevertheless, debt interest and principal, must be repaid at certain specified times, regardless of the enterprises financial condition. Generally, a failure to pay principal or interest may result in proceedings where equity investors lose control of the enterprise as well as all or part of their investment. If all the equity capital is wiped out by losses creditors may also lose part or all of their investment. The contractual nature of debt finance makes it crucial that its underlying conditions are complied with by borrowers. Simply put, the larger the proportion of debt in the total capital structure of an enterprise, the higher the servicing commitment and the greater the probability of a chain of events leading to an inability to pay interest and principal where due. This is the idea of an enterprise being ‘highly geared’ or dependent on debt for financing its operations. It is clear that both benefits and risks are apparent with the use of debt finance. Anyone investing equity in a firm should realise that the existence of debt represents a risk of loss of the investment. This risk is balanced by the potential high profits arising from the use of gearing / financial leverage. It should be remembered that excessive use of debt may stifle management initiative and flexibility for profitable action. The cost of failure being more significant when debt funds are used and from the creditors point of view, they prefer a large capital base because this may cushion the impact of adversity and reduce the chance of losses. The greater the proportion of debt in total capital the smaller is the creditors cushion against loss and greater the risk of loss. Simply put, in the case of identical entities, the creditor exposes himself to greater risk if he lends to the company with 60% of its funds provided by debt (40% equity) than if he lends to a company with 20% debt (80% equity) Why use debt if it is potentially dangerous to an enterprise? There are a range of reasons why debt can be beneficial. One is that debt is a useful hedge against inflation. The real value of funds borrowed depreciates in times of rising inflation thus what is actually repaid by the borrower over a period of years has a lower purchasing power than at the original time of receiving the debt funds.

Another primary reason for using debt for the firm is from the point of view of ownership, a less expensive source of funds than equity capital. Usually the interest cost of debt is fixed (unless funds are borrowed on a variable basis) and thus as long this cost is lower than the return that can be earned on the funds supplied by creditors, this excess accrues to the benefit of equity holders. Unlike dividends, which are considered a distribution of profits, interest is considered an expense and is consequently, tax deductible. The effect of the tax deductibility of interest can be illustrated with the following example. Company x & Company y both have $1m of assets. Company x has funded its assets with $600,000 of $1 equity shares and $400,000 of debt. Company y has funded its assets with $1m equity shares of equity. Interest is payable @ 10%. Company tax is payable @ 30%. Income in this year for both firms is $200,000.

Income before interest & taxes Interest payable(10% of 400,000) Income before taxes Less Taxes 30% Profit after tax Less Dividends of 10c per share paid Profit after tax interest and dividends

Company x 200,000 40,000

Company y 200,000 0

160,000 48,000 112,000 60,000

200,000 60,000 140,000 100,000

52,000

40,000

The above example illustrates that the use of debt can bring higher overall returns because of its treatment as a pre-tax expense. This advantage of debt finance is shown in the case of Company x where there are $52,000 of returns available for distribution, $40,000 to the contractual creditors who have loaned the enterprise money and $60,000 for dividends. Leaving 52,000 that can be retained to which may be retained by the enterprise for growth. The example of Company y shows that an absence of debt in this case reduces the returns available for distribution, the advantage of interest being a pre-tax expense is not utilised by the firm in this case. They end up with $40,000 after tax and dividend distribution. It should be clear by now that neither debt nor equity finance are good or bad in their own right. Both have their own merits and it is the blend of the two which is usually important. The funding of assets should matched to the flow of cash those assets will ultimately generate. Both debt and equity finance can in their way serve this need. It is up to financial managers to determine what is required in the particular circumstances....