Businesses have to make a fundamental decision on whether to borrow money when they are in need of capital or attract investors. On the face of it, borrowing would appear more costly – after all, you have to repay it with interest. In finance, however, the debt is nearly always deemed cheaper as compared to equity. It makes sense why it affects the way you think about financing your business completely. This is a concept that you should understand regardless of whether you are a startup founder or an experienced business owner in order to make smarter capital structure decisions. We will dissect it into plain and simple.
Why is Debt Financing Generally thought to be cheaper than Equity Financing?
The brief reply is that lenders are less risky than investors – and reduced risk translates to reduced cost to you. Borrowing money means that you would be repaying a certain amount of money with an interest over some time. By introducing equity investors you cede a portion of your business, such as a portion of all future gains, possibly permanently. In terms of cost of capital analysis, that continued cost of ownership is nearly always greater than the fixed cost of debt throughout the life of a business.
Interest Payments vs. Dilution of ownership.
- There is a known and determined cost of debt, your interest rate. After repayment of the loan, the lender makes no further claims on your business or the profits of your business. Equity on the other hand offers the investors a permanent part of all that your business makes and so, it becomes very costly as your business becomes more successful as time goes by.
- Equity financing dilutes ownership and permanently decreases your future profit and business value. The strategy of capital structure that is heavily based upon equity implies that you are sharing upside of all the good decisions that you make indefinitely with investors who did lend you capital at some point of time.
Reduced Risk to Lenders than Investors.
- The lenders are paid off prior to the equity investors in case the business gets into trouble- they are in a more secure position. They are also less risky hence are willing to take a lesser return, which directly translates to lesser cost of capital to the business that is taking the loan as opposed to the expectations of equity investors.
- The greatest risk of any capital provider is equity investors as they will be the last to get anything in case the business struggles. In order to pay them off, they require much greater returns – so on a cost of capital analysis perspective, equity is the most expensive form of capital in virtually all circumstances.
What is the relation between tax advantages and why is debt a cheaper source of finance?
It is in this place that debt becomes even more appealing. The interest charged on business debt is usually deductible tax-wise, that is, the IRS in effect subsidizes a portion of your cost of debt. In contrast, dividend payment to equity investors is after-tax profit and is not tax-deductible. This tax benefit has a significant impact on the actual cost of debt when it is used as an integral part of a comprehensive capital structure approach of any business.
Effect on Total Cost of Capital.
It is due to this deductibility that the after-tax cost of debt is always less than the stated interest rate. To illustrate, when a business is charged with 8 percent interest on a loan and falls in a 25 percent tax bracket, then the business actually pays a 6 percent interest after the tax deduction. There is no similar reduction in the case of equity financing – so the tax treatment of interest is one of the most significant elements in any cost of capital analysis when dealing with the alternatives of funding a growing business.
What is the Role of Risk in Cost of Debt vs. Cost of Equity?
The core of the difference in the cost of debt and equity is risk pricing. All the capital providers, the bank and the investor will price their money according to the risk they are undertaking. The greater their risk, the greater their return. This is one of the principles that must be understood in order to have a serious discussion on capital structure strategy.
Fixed Returns and Variable Returns.
- Debt has predetermined, contractual returns to the lender – a predetermined interest rate independent of the performance of the business. This predictability leads to the lender having less risk and thus a reduced required return which directly equates to a reduced cost of financing to the business that borrows the funds.
- The equity investors are given a fluctuating rate of returns which are all dependent on the performance of the business. During a bad year they might get nothing. They might make a lot of returns in a big year.
What is the benefit of Debt Financing to the Control and Ownership by the Business?
Other than cost, debt financing has one more great benefit that equity can not even remotely compete with, you retain complete control of your business. No seats on the board, no approvals of investors, no sharing of strategic decisions. In cases where business owners have created something valuable and wish to continue to control it, the capital structure strategy based on debt does not dilute that control in any way.
Maintaining Decision-Making Power
The lender does not own anything or have a say in the running of your business when you incur debt. After repayment, the relationship is terminated altogether. Equity investors, on the other hand, are usually accompanied by governance rights, such as the power to affect or veto important business decisions based on their share in the company and the nature of their investment contract.
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Conclusion
It is not only a financial decision but a strategic decision that you have to choose between debt and equity which influences your tax position, your ownership and your long-term business worth.. To do it right, you need the cost of capital analysis, and an effective capital structure plan that fits your scenario. Epicwayz Advisors is a reliable business advisory firm located in Plano, which assists business owners to make a clear and confident evaluation on funding decisions.
