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Debt vs. Equity: Compare and Contrast Essay

2021-08-25 20:06:19
5 pages
1315 words
University/College: 
George Washington University
Type of paper: 
Course work
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There are various resources for funding a business that can be utilized by business owners, these sources initially were categorized into debt funding and also equity funding. Equity funding involves selling interests and shares of the company to enterprises, which means that part of the business control is sold to raise funds for business purposes (Forbes, & Warnock, 2012). On the other hand, debt funding refers to a resource of business funds that involves borrowing of money to run a business. Debt funding can either be long term or short term (Covas, & Den Haan, 2012). This paper analyses debt vs. equity funding sources for business investment. The paper takes a look at the advantages and disadvantages of both and finally weighing the better way method of sourcing business funds.

Advantages of Debt funding

Maintaining ownership of the business: when debt is used to fund a company, one retains the ownership and the right to operate the business without any interference from the outside. This is attained through the obligation made by the borrower to make payments on time. Apparently, the money lender does not take any position in the business (Pazarbasioglu, et al, 2011).

Tax deductions: this is the primary attraction for debt financing of a business. In many cases, the interest payments on a loan of a given company are regarded to like expenses of the business and therefore, can be deducted from the income during the tax time. In cases of long-term financing, the repayment time frame can be extended over an extended period and therefore, the monthly expenses reduced significantly (Maes, & Schoutens, 2012).

A cheaper form of financing: debt funding is regarded to be a cheaper form of fund source as compared to equity funding. When the company gets funds through debts, there is no obligation to the business to be paying dividends to the money lenders who may need specific return rates. Therefore it is a less risky ways funding a company for an investor because the business is legally obligated to make the repayment entirely and on time with an agreed interest (Pazarbasioglu, et al, 2011).

A limited obligation to lenders: In case a company runs bankrupt or getting dissolved, the debt holders are in the position to make claims on the business assets. Thus their security is guaranteed. Apparently, since debt has limited risk, it is therefore rendered cheaper as compared to equity source of funding. Consequently, debt holders have a higher hand in getting back their money as compared to equity holders who lose everything in case the firm runs bankrupt (Maes, & Schoutens, 2012).

Disadvantages of debt funding

In debt funding, there are limited risks for the debt holder but higher risk to the borrower. This means that the business that is funded with debt takes a higher risk since debts need to be serviced by paying interest to the debt holder. According to obligations during taking debts, the interests repayments should be repaid back regardless if the company makes a profit or not as well as interference by any economic conditions. It has been observed that firms with large debts suffer tremendous pressure during economic crisis since the interest will shoot higher in case of delays on repayment (Maes, & Schoutens, 2012).

Maes, & Schoutens, (2012), Sometimes, banks and some other money lending groups would fear to lend some huge amounts of money to borrowers; therefore if a company had depended solely on debt as a source of sending, it would automatically cause inconvenience.

Thirdly, debts can sometimes become over-leveraged; this means that the cost of raising additional debts for a firm becomes more expensive than initially. This concept is put in place by the fact that the initial lender would lay their claims on the companys assets. Apparently, the subsequent debt holder will charge higher than the initial lender since lending becomes riskier (Pazarbasioglu, et al, 2011).

Advantages of Equity funding

When using equity finance for funding a business, there will be no costs required to service the bank loans as well as debts. Therefore, allowing the businesses to use the capital for other business activities instead (Covas, & Den Haan, 2012).

In a business funded by equity funds, there will be diverse stakeholders in the company thus bringing different ideas that can make the business grow and do exceptionally well and this is through the introduction of new valuable skills as well as experience in the business which will, in turn, offer success path towards the company (Pazarbasioglu, et al, 2011).

Maes, & Schoutens, (2012), at times, some shareholders are likely to bring along follow up funds to boost the business and consequently offering a success path for the business.

Disadvantages equity funding

During the time of raising equity finance, it is time-consuming and very costly; as a result, the management attention may be drawn away from the core focus of the business (Maes, & Schoutens, 2012).

When investing in business through equity funding, one is likely to lose power over the business management decisions (Pazarbasioglu, et al, 2011).

Sometimes, raising funds through equity funding may be at times be hindered by some regulatory issues (Pazarbasioglu, et al, 2011).

According to the case scenario, company A has a lower long-term debt as compared to company B. also, the shareholder equity of company A is higher as compared to company B. apparently, and Company A uses equity funds to finance their business, while company B use debt funding for their source of finance. Basically, from the outlook of the net income, company B has a lower net income as compared to company A, since company A does not use any of their income to service bank loan of debt capitals. Company B, on the other hand, has to service the debts regardless of losses in their operations, thus resulting in a lower net income in their financial statement. Importantly to note, the servicing of the debts and bank loans, there are interest charges as well on top of the normal repayment of the initial debt taken.

Also, on December 31 2xx5 the companies paid an interest of 10percent on the outstanding long-term debt. 10percent debt of company A sums up to $1000, whereas company B paid and interest of $9000 which is a considerable amount comparatively. Therefore, when doing a comparison, it is automatic that company A would have a higher net income as compared to company B which spent more of their capital in servicing their loans.

R. Flosman has a belief that company A is the best to invest in just because of the income net that reflected in the financial statement. This view is wrong since Flosman has no clear picture of the advantages and disadvantages of both companies regarding the funding sources for both companies. As aforementioned, debt funding for a business is advantageous and much cheaper for business as compared to equity funding. Therefore it is advisable to invest in company B.

Conclusion

Businesses have various funding sources which are largely categorized to equity and debt funding. Both the sources of funding have their advantages and disadvantages. Debt funding is cheaper as compared to equity funding regarding the outcomes. However, firms sourcing their funding through debt must repay the loans with interest. On the other hand, equity lays a more significant risk to the shareholder in case the business runs bankrupt. Debt holders can claim the companys assets in case the business runs bankrupt, therefore increasing security for debt holders. Finally, a debt-funded company is the ideal for investment as compared to an equity-funded business.

References

Covas, F., & Den Haan, W. J. (2012). The role of debt and equity finance over the business cycle. The Economic Journal, 122(565), 1262-1286.

Forbes, K. J., & Warnock, F. E. (2012). Debt-and equity-led capital flow episodes (No. w18329). National Bureau of Economic Research.Maes, S., & Schoutens, W. (2012). Contingent Capital: An InDepth Discussion. Economic notes, 41(12), 59-79.Pazarbasioglu, C., Zhou, M. J. P., Le Lesle, V., & Moore, M. (2011). Contingent capital: economic rationale and design features. International Monetary Fund.

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