Welcome to Alanis Business Academy. I’m Matt
Alanis and this is An Introduction to Debt and Equity Financing. Finance is the function responsible for identifying
the firm’s best sources of funding as well as how best to use those funds. These funds
allow firms to meet payroll obligations, repay long-term loans, pay taxes, and purchase equipment
among other things. Although many different methods of financing exist, we classify them
under two categories: debt financing and equity financing. To address why firms have two main sources
of funding we have take a look at the accounting equation. The basic accounting equation states
that assets equal liabilities plus owners’ equity. This equation remains constant because
firms look to debt, also known as liabilities, or investor money, also known as owners’ equity,
to run operations. Now lets discuss some of the characteristics
of debt financing. Debt financing is long-term borrowing provided by non-owners, meaning
individuals or other firms that do not have an ownership stake in the company. Debt financing
commonly takes the form of taking out loans and selling corporate bonds. For information
on bonds select the link above to access the video: How Bonds Work. Using debt financing provides several benefits
to firms. First, interest payments are tax deductible. Just like the interest on a mortgage
loan is tax deductible for homeowners, firms can reduce their taxable income if they pay
interest on loans. Although deduction does not entirely offset the interest payments
it at least lessens the financial impact of raising money through debt financing. Another benefit to debt financing is that
firm’s utilizing this form of financing are not required to publicly disclose of their
plans as a condition of funding. The allows firms to maintain some degree of secrecy so
that competitors are not made away of their future plans. The last benefit of debt financing
that we’ll discuss is that it avoids what is referred to as the dilution of ownership.
We’ll talk more about the dilution of ownership when we discuss equity financing. Although debt financing certainly has its
advantages, like all things, there are some negative sides to raising money through debt
financing. The first disadvantage is that a firm that uses debt financing is committing
to making fixed payments, which include interest. This decreases a firm’s cash flow. Firms that
rely heavily in debt financing can run into cash flow problems that can jeopardize their
financial stability. The next disadvantage to debt financing is
that loans may come with certain restrictions. These restrictions can include things like
collateral, which require the firm to pledge an asset against the loan. If the firm defaults
on payments then the issuer can seize the asset and sell it to recover their investment.
Another restriction is a covenant. Covenants are stipulations or terms placed on the loan
that the firm must adhere to as a condition of the loan. Covenants can include restrictions
on additional funding as well as restrictions on paying dividends. Now that we have reviewed the different characteristics
of debt financing lets discuss equity financing. Equity financing involves acquiring funds
from owners, who are also known as shareholders. Equity financing commonly involves the issuance
of common stock in public and secondary offerings or the use of retained earnings. For information
on common stock select the link above to access the video: Common and Preferred Stock. A benefit of using equity financing is the
flexibility that it provides over debt financing. Equity financing does not come with the same
collateral and covenants that can be imposed with debt financing. Another benefit to equity
financing also does not increase a firms risk of default like debt financing does. A firm
that utilizes equity financing does not pay interest, and although many firm’s pay dividends
to their investors they are under no obligation to do so. The downside to equity financing is that it
produces no tax benefits and dilutes the ownership of existing shareholders. Dilution of ownership
means that existing shareholders percentage of ownership decreases as the firm decides
to issue additional shares. For example, lets say that you own 50 shares in ABC Company
and there are 200 shares outstanding. This means that you hold a 25 percent stake in
ABC Company. With such a large percentage of ownership you certainly have the power
to affect decision-making. In order to raise additional funding ABC Company decides to
issue 200 additional shares. You still hold 50 shares in the company, but now there are
400 shares outstanding. Which means you now hold a 12.5 percent stake in the company.
Thus your ownership has been diluted due to the issuance of additional shares. A prime
example of the dilution of ownership occurred in in the mid-2000’s when Facebook co-founder
Eduardo Saverin had his ownership stake reduced by the issuance of additional shares. This has been An Introduction to Debt and
Equity Financing. For access to additional videos on finance be sure to subscribe to
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