Companies often raise money via one of two primary channels: either debt or equity. There are significant distinctions between equity and debt financing, even though both may provide a company with the essential money to remain operational. Both traditional and alternative forms of finance come with their own set of advantages and drawbacks, though. In the following, we will compare and contrast two different types of capital: debt and equity.
Debt Capital
The term "debt capital" refers to monies that have been borrowed and will need to be returned at a later period. This refers to any expansion capital that a firm acquires via debt financing, such as loans. These loans might be short-term, such as overdraft protection, or long-term, like home equity loans. The use of debt finance does not diminish the interest that a business's owner has in the company. However, until its debts are paid off, paying the interest on those loans may be burdensome, particularly when interest rates increase.
Before legally handing out dividends to shareholders, businesses must first satisfy their interest obligations related to their outstanding debt. Because of this, debt capital will now take precedence over yearly profits on a company's list of goals. Lenders often seek interest payments from borrowers in exchange for the use of their money, even though debt enables businesses to double the impact of even a modest amount of capital. This interest rate represents the expense of using loan capital. For companies experiencing financial difficulties, obtaining debt financing may also be challenging and may demand the provision of collateral.
Cost of Debt Capital
If an organization borrows one hundred thousand dollars at an interest rate of seven percent, the cost of equity difference for the loan is also seven percent. When determining the true cost of debt capital, firms consider the corporate tax rate by multiplying the interest rate by the inverse of the rate at which the corporation is taxed. This brings the total cost of loan capital to reflect the true market value of the debt. Assuming that the corporation tax rate is 30 percent, the cost of capital for the loan described in the previous example is 0.07 times (1 minus 0.3), equal to 4.9 percent.
Equity Capital
The cost of equity capital is often somewhat more complicated than other types of capital because it originates from cash contributed by shareholders. Because a company doesn't have to take on debt to access equity capital, the money invested does not have to be returned. The performance of the market as a whole and the volatility of the stock in question both have a role in determining how much return on investment (ROI) owners may reasonably anticipate getting from their investments.
To keep investor interest, businesses need to be able to provide returns for their shareholders in the form of robust stock prices and dividends that reach or surpass this threshold. To calculate the anticipated rate of return or cost of equity, the capital asset pricing model (CAPM) considers the risk-free rate, the risk premium of the broader market, and the beta value of the company's shares.
Ownership of Equity Capital
Equity capital indicates ownership when compared to debt capital, while debt capital indicates a commitment. The cost of equity often comes in at a higher level than the cost of debt. Since the payment of a loan is required by law regardless of a company's profit margins, the risk posed to shareholders is larger than the risk posed to lenders. The following are some of the forms that equity capital may take:
- The sale of common stock to shareholders is one method businesses use to obtain capital. The company's common shareholders have voting rights on specific issues.
- Preferred Stock: This stock does not offer voting rights to shareholders but does grant ownership in the firm. Preferred stock also grants ownership in the company. If the company is forced into liquidation, these shareholders will be compensated first before regular investors.
- The firm's earnings throughout its existence are referred to as "retained earnings." These earnings have not been distributed to shareholders in the form of dividends.
- In the balance sheet portion devoted to stockholder's equity, a corporation will detail its equity capital investments. In the event of a sole proprietorship, it will be included in the part devoted to the owner's equity.
