Financial Planning and Management

1. Compare Debt and Equity Finance

Description- Debt Finance

Debt financing often means borrowing money by the business, which must be repaid (including interest) over a fixed period or periods of time. It usually occurs when a firm raises money for working capital or capital expenditures through selling bonds, bills or notes to individuals and or institutional investors.^[1] However, in return for borrowing money, the individuals or institutions become creditors and receive a promise the principal and interest on the debt will be repaid.  

Advantages

Debt financing is easier to arrange and generally can done so within short notice. The bank or lending institution (such as the Small Business Administration) has no say and ownership in the way an owner run their company. However, the business relationship ends once the owner fully repaid the loan. The interest on the loan is tax-deductible, effectively reducing the net obligation of the company. Principal and interest are known, making it easier to budget and make financial plans.

Disadvantages

Debt financing has increased levels of debt mean that the company is higher risk of being liquidated when the company fails to meet its commitment such as repaying the loan, plus interest. Some debt holders may only issue debt that entails covenants or restriction on company actions. This puts a strain on the company’s operations and decision making. Acquiring additional debt may send a negative message to the company’s shareholders, and thus cause a downward trend in the value of the company’s stock.

Description- Equity Finance

Equity Financing is the process of increasing capital through the sale of shares on an enterprise. It is generally referring to the sale of an ownership interest to raise funds for business purposes. The shareholders received ownership interests in the company, in return for the investment.  Equity financing spans a wide range of activities in scale and scope, from a few thousand dollars raised by an entrepreneur from friends and family, to giant initial public offerings (IPOs).^[2]

Advantages

Owners do not have to be repaid for their capital after a certain period, and there are no fixed rates of return on their investment that must be paid. In periods where the firm has not generated sufficient profits, the owners may not receive any return from the company. In this respect, equity financing imposes fewer financial constraints on the business. The rate of return on investments paid to equity holders is generally lower than for debt holders, partly because they are rewarded by the increase in the value of their shareholding.