Question

To raise capital, corporate officers have two basic sources of funding from which to choose: (1) debt (i.e., issuing bonds, taking out a loan) or (2) equity (i.e., issuing more stock). What are the trade-offs between these two very different sources of capital? Consider tax and nontax factors.

Answer 1

Debt and Equity sources of finance both have their pros and cons.

Debt is beneficial because the interest payment on debt is tax deductible and so the cost of financing reduces. This benefit is not there is equity financing since dividend payments are appropriations of profits and not tax deductible. Debt holders also do not participate in the decision making and have no voting rights so the ownership is not diluted. Under equity financing, equity shareholders are the owners of the business and have their own voting rights.

Debt holders however are creditors of the business and have a preference at the time of dilution of the business. Debt financing reduces the credit worthiness of the business. Equity holders need not be paid off if nothing is left at the time of liquidation. Equity financing increases the goodwill and creditworthiness of the business due to higher investor confidence.