Debt Financing vs Equity Financing

When it comes to debt finance and equity finance, there is often debate as to which way is the best to finance a business? Dobson (1999) explains how the ultimate objective of a business is to maximise shareholder wealth. Therefore shareholder wealth maximisation is likely to be the main consideration of firms when deciding which method of finance is best. For the purposes of this blog, debt finance will refer to the raising of capital through the issue of bonds and equity financing will refer to the raising of capital through the issue of equity in a firm. This blog will assess the advantages and disadvantage of each of these sources of finances and finally consider which is best for a firm.

Equity Finance

The main advantage of equity finance is that it avoids the burden of debt. Therefore it is a much less risky option and much more affordable option as nothing is required to be paid back. This also allows for the firm to take a longer term view as they do not need to worry about generating short term returns in order to maintain debt repayments. However equity financing does also carry disadvantages. Firstly the firm is actually selling ownership which means that current ownership becomes diluted. Unlike debt financing, investors will also expect profits to be paid back in the form of dividends. Investors will also have to be consulted before decisions and will want the firm to be run in their own interests, which may not always be best.

Debt Finance

Debt finance tends to be cheaper to firms that equity finance as the lenders tend to require a lower rate of return than shareholders. Debt finance can also reduce the amount of tax that is paid as debt can be offset against profits as interest is tax deductable. Other costs such as issuing and transaction costs also tend to be lower, along with certainty regarding the amount that will be repaid. However debt financing does carry disadvantages. Unlike equity finance, money must be repaid on a set date as it is essentially a loan. A firm that is too highly geared may find it difficult to repay loans on time, which can also lead to other factors such as a short term approach taken by the firm to ensure sufficient cash is generated. Firms taking on debt finance therefore run the risk of bankruptcy through failure to repay loans, making such option riskier.

From a financial point of view it would initially appear that if a firm need to generate capital, the best option is debt financing as it is the cheapest method for raising capital. Therefore this would assume that taking on greater levels of debt compared to equity reduces the weighted average cost of capital (WACC) which benefits shareholders as overall costs are reduced. However a number of financial experts suggest that as levels of risk are increased due to greater risk involved regarding the repayment of debt, shareholders actually in turn demand a greater return. Therefore as shareholders require a greater return to compensate for the enhanced risk undertaken by the company, this can actually lead to a destruction of wealth overall as share price in fact decreases due to the increased requirement outweighing any benefits of financing through debt. I think it would be fair to say that each situation and each company is different and there is no right or wrong answer to the best method of financing. However in order to ensure that shareholder wealth is maximised, firms do need to ensure that if financing through debt, levels are controlled to reduce the risk of bankruptcy and therefore ensure shareholders do not require excessive returns to compensate, thus diminishing wealth.  

References in this blog

Dobson, J. (1999). Is Shareholder Wealth Maximization Immoral?. Financial Analysts Journal, 69-75.