The Debt Or Equity Decision
A business normally needs funding. This can be in the form of debt or from equity financing.
The following are some of the considerations that can influenced us on the choice/type of finance:
- The relative cost of finance
Debt finance is usually cheaper than equity finance because debt finance is safer from a lender’s point of view as interest has to be paid before dividend. In the event of liquidation, debt finance is paid off before equity. This makes debt a safer investment than equity and hence debt investors demand a lower rate of return than equity investors.
The cost of finance should also include any administrative costs involved in raising the capital
- The effects of taxation
Debt interest is also corporation tax deductible (unlike equity dividends) making it even cheaper to a taxpaying company.
- The current capital gearing of the business.
Although debt is attractive due to its cheap cost, its disadvantage is that interest has to be paid. If too much is borrowed then the company may not be able to meet interest and principal payments and liquidation may follow. The level of a company’s borrowings is usually measured by the capital gearing ratio (the ratio of debt finance to equity finance) and companies must ensure this does not become too high. Comparisons with other companies in the industry or with the company’s recent history are useful here
- Security available.
Many lenders will require assets to be pledged as security against loans. Good quality assets such as land and buildings provide security for borrowing – intangible assets such as goodwill, patents or trademarks usually do not. In the absence of good asset security, further borrowing may not be an option.
- The nature of conditions imposed by lenders on a company’s freedom of action eg restrictions on future borrowing ability if assets are pledged.
- Business risk.
Business risk refers to the volatility of operating profit. Companies with highly volatile operating profit should avoid high levels of borrowing as they may find themselves in a position where operating profit falls and they cannot meet the interest bill. High-risk ventures are normally financed by equity finance, as there is no legal obligation to pay equity dividend.
- Operating gearing.
Operating gearing refers to the proportion of a company’s operating costs that are fixed as opposed to variable. The higher the proportion of fixed costs, the higher the operating gearing. Companies with high operating gearing tend to have volatile operating profits. This is because fixed costs remain the same, no matter the volume of sales. Thus, if sales increase, operating profit increases by a larger percentage. But if sales volume falls, operating profit falls by a larger percentage. Generally, it is a high-risk policy to combine high financial gearing with high operating gearing. High operating gearing is common in many service industries where many operating costs are fixed.
- Dilution of earnings per share (EPS).
Large issues of equity could lead to the dilution of EPS if profits from new investments are not immediate. This may upset shareholders and lead to falling share prices.
- Voting control.
A large issue of shares to new investors could alter the voting control of a business. If the founding owners hold over 50% of the equity they may be reluctant to sell new shares to outside investors as their voting control at the AGM may be lost.
- The current state of equity markets.
In a period of falling share prices many companies will be reluctant to sell new shares. They feel the price received will be too low. This will dilute the wealth of the existing owners. Note this does not apply to rights issues where shares are sold to the existing owners of the company.
Or in a severe “credit squeeze” which may make it impossible to obtain short-term bank finance or the capital market may be “saturated” with new issues.
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- Capital Asset Pricing Model(CAPM)
- Non-Financial and Qualitative Factors in Credit Decision
November 21, 2006
Posted in: Sources of Financing
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