Why Is Debt Cheaper Than Equity?

Why Is Debt Cheaper Than Equity

The comparison of debt and equity is one that every entrepreneur ought to have a clear picture of. When companies talk about equity versus debt, it is usually a comparison of the inherent cost of getting the required financing. This added capital is often needed for funding operations or expansion. For companies, the two ways for financing includes through sell stakes (equity) and via loans. When drawing a comparison between equity and loans, it is imperative to note what the company would be paying over the lifetime of the loan. It suffices to say that if the interest that is payable on the loan is lower than an investor’s share on the profit of the company, and then the debt is expected to be cheaper.

Why is debt cheaper than equity?

Debt is cheaper than equity for several reasons. The primary reason for this, however, is that debt comes without tax. This simply means that when we choose debt financing, it lowers our income tax. Because it helps removes the interest accruable on the debt on the Earning before Interest Tax. This is the reason why we pay less income tax than when dealing with equity financing. In the case of equity financing, there is no such thing as interest on equity but we have a dividend. Due to this reason, EBT in equity financing is usually more than it is in the case of Debt financing and it is the same rate in both instances. 

In the case of debt financing, EPS is usually more than in the case of equity financing. The reason for this is that in the case of equity financing, the share number is increased more than before. In this case, there is no alteration in the share number in debt financing.

Why Should I Choose Debts Over Equity?

We have been able to establish that debt trumps equity when it comes to financing. When it comes to a time when owners of startup companies think about growth capital, they seldom think about debt financing. One thing about venture capital is that they usually have higher mindshare. Because of this, several founders are quite anxious about collecting funds with have a repayment cap or interest rates.

This, however, should not be the case. The simple reality is that financing your company growth using debt is not the same as exceeding the limit of your credit cards. For instance, you are bound to have customers who are willing to pay which means revenue. This is added to the fact that you have an accounting function. This means that debt will be easy to account for. Also, it means that you will know your repayment obligations in advance and as such, you can plan.

Also, debt financing brings a lot of benefits you may not be aware of. Some of the unique benefits of debt financing include the following:

1. Unique tax benefits

In a case where your company is faced with financial issues, debt financing gives you what equity financing will not be able to. For instance, if your company uses accrual accounting, the interest of the payment is often a part of the loss and profit payments. This, therefore, means a reduction in your taxable income. It suffices to say that the cost of borrowing will be lower than the interest rate stated. It suffices to say that the American government helps you in mitigating the cost of the loan procured.

2. Debt is cheaper than equity in the long run

Several entrepreneurs have the erroneous belief that venture capital is free money. The truth is that it is not and, if you intend to make any meaningful progress, debt is the best way to go.

3. Autonomy in running your business

More often than not, a lender will not come to tell you how you should run your organization. However, by taking equity, it means that you will be having the investors on the board of your company. This also means that you will have to conform to their expectations as regards how your company should be run. There are instances where the control of the owner of such a business gets limited because of conflict with the investors. But in the case of lenders, all they are interested in is that you are up to date with your payments. They do not require seats on your board or a controlling stake.

4. Extra push

For companies that are at their early stage of development with recurrent streams of revenue, a minor debt amount will lead to an increase in net cash flow. The added funds will mean an increase in the overall cash flow. This extra cash will invariably mean you can hire some extra hands. If you are lucky enough to hire the right people, it will reflect in the overall productivity of your business. this will reflect in your sales and overall ROI.

5. Luxury of time

One of the major drawbacks of equity financing is that it usually takes a lot of time for the funds to be raised. Also, it takes a whole lot of effort to raise the funds, with phone calls, pitches, coffee meetings and the likes. Debt financing is usually quite quick. Debt helps save you the time needed to run your business. Also, lenders are never interested in keeping up with each decision you make and they usually do not need board meetings. Furthermore, money lenders do not bother themselves with your strategy or hiring process.

What Is The Cost Of Debt Financing?

The capital structure of a firm is usually composed of both debt and equity.  The equity cost is the dividend that is paid off to the shareholders. In the case of debts, the company does not only promise to pay the loan, but it does so with interests. The cost of payment of the debt instruments is simply the cost of borrowing.

The cost of capital is the sum of the cost of debt financing and equity financing. The capital cost simply represents the lowest return which a company has to make on the capital if it seeks to please its creditors, shareholders, and capital providers. Every decision of a company as regards investments must generate returns that should be more than the capital cost. In a case where the returns on capital expenditures are lower than the capital cost, then such a company is on a positive note.

What Is Debt Financing?

Debt financing takes place when a company sells certain fixed products such as bills, bonds, and notes. This is done to get the much-needed capital to expand and grow its operations. In a situation where a company issues bonds, the people who buy such bonds are investors who give the company the needed debt financing. This loan must be paid after some time at the date agreed. In a case where the company closes business, the lenders are at liberty to sell off the company assets to recover their funds.

What Should I Know About The Interest Rate In Debt Financing?

Several investors that are in debt are simply interested in principal protection; others simply look for a return in the form of interest. The interest rate is usually determined by the borrower’s creditworthiness and market rates. When there is a higher payment rate, it simply implies that the borrower has a higher tendency of defaulting. This, therefore, means he or she is a higher risk investment. The higher rates are a way of compensating the borrower for the higher risks. Aside from the interests’ payable, debt financing also necessitates the borrower to strictly adhere to some rules. Such rules are known as covenants.

Debt financing is always quite difficult to get. However, for several companies, it usually means funding at rates lower than that of equity financing. As discussed earlier, debt financing offers borrowers tax-deductible funding. However, one needs to be careful with debt financing because having too much debt may affect the cost of capital. This, in turn, leads to a reduction in the value of your organization.

What Does The Debt-Equity Ratio Mean?

A company’s character in financing is a function of its debt-equity ratio. Lenders are always motivated by a lower debt-equity ratio as it implies that the company is more investment-based. It, therefore, translates to higher investor confidence in the business. in a case where the debt-equity ratio is high, it means that the company has too much borrowings on a comparatively small investment base.

Conclusion

The funding process you go for today will go a long way in determining what it is you can do with your enterprise. It is therefore imperative that you be mindful of your funding options especially during the early days of your business. You need to picture where you want to see your company in the next ten years. You also need to ask yourself how much control you are willing to relinquish in a bid to grow your company. In summary, debt financing beats equity on several grounds as has been explained here. It is however important that you think deep and hard before making your decision.

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