How to finance your company/project/acquisition?
When financing a company with debt, the cost of capital is the interest expense a company pays on its debt. With equity, the cost of capital refers to the claim on earnings provided to shareholders for their ownership stake in the business.
When a firm raises money for capital by selling debt instruments to investors (including banks), it’s known as debt financing. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid on a regular schedule.
Equity financing is the process of raising capital through the sale of shares in a company. With equity financing comes an ownership interest for shareholders. Equity financing may range from a small amount of money raised by an entrepreneur from a private investor to an initial public offering (IPO) on a stock exchange running into the billions.
Provided that the company is expected to perform well, you can usually obtain debt financing at a lower effective cost. Why?
For example, if you run a small business and need 50,000 of financing, you can either take out a 50,000-bank loan at, say, an 8% interest rate or, you can sell a 20% stake in your business for 50,000.
Let’s suppose your business earns a 25,000 profit during the next year. If you took the bank loan, your interest expense (cost of debt financing) would be 4,000 (50,000 x 8%), leaving you with 21,000 in profit. Additionally, the interest expense is deducted from earnings before income taxes are levied, thus acting as a tax shield. Conversely, had you used equity financing, you would have zero debt (and as a result, no interest expense), but would keep only 80% of your profit. Therefore, your personal gain would only be 20,000 (80% x 25,000).
From this example, you can see how it is less expensive for you, as the original shareholder of your company, to issue debt as opposed to equity. Obviously, new businesses may have a difficult time obtaining debt financing and often finance their operations mostly through equity.