Financing with debt

Debt financing occurs when a firm raises money for working capital or capital expenditures by selling debt instruments to individuals and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid. The other way to raise capital in debt markets is to issue shares of stock in a public offering; this is called equity financing.

A company can choose debt financing, which entails selling fixed income products, such as bonds, bills, or notes, to investors to obtain the capital needed to grow and expand its operations. When a company issues a bond, the investors that purchase the bond are lenders who are either retail or institutional investors that provide the company with debt financing. The amount of the investment loan also known as the principal must be paid back at some agreed date in the future. If the company goes bankrupt, lenders have a higher claim on any liquidated assets than shareholders.

Cost of Debt

A firm’s capital structure is made up of equity and debt. The cost of equity is the dividend payments to shareholders, and the cost of debt is the interest payment to bondholders. When a company issues debt, not only does it promise to repay the principal amount, it also promises to compensate its bondholders by making interest payments, known as coupon payments, to them annually. The interest rate paid on these debt instruments represents the cost of borrowing to the issuer.

The sum of the cost of equity financing and debt financing is a company’s cost of capital. The cost of capital represents the minimum return that a company must earn on its capital to satisfy its shareholders, creditors, and other providers of capital. A company’s investment decisions relating to new projects and operations should always generate returns greater than the cost of capital. If a company’s returns on its capital expenditures are below its cost of capital, the firm is not generating positive earnings for its investors. In this case, the company may need to re-evaluate and re-balance its capital structure.

The formula for the cost of debt financing is:

KD = Interest Expense x (1 – Tax Rate)

where:

KD = cost of debt

Since the interest on the debt is tax-deductible in most cases, the interest expense is calculated on an after-tax basis to make it more comparable to the cost of equity as earnings on stocks are taxed.

Debt Financing Options

Bond issues

Another form of debt financing is bond issues. A traditional bond certificate includes a principal value, a term by which repayment must be completed, and an interest rate. Individuals or entities that purchase the bond then become creditors by loaning money to the business.

Bank loan

A common form of debt financing is a bank loan. Banks will often assess the individual financial situation of each company and offer loan sizes and interest rates accordingly.

Family and credit card loans

Other means of debt financing include taking loans from family and friends and borrowing through a credit card. They are common with start-ups and small businesses.

Debt Financing Over the Short-Term

Businesses use short-term debt financing to fund their working capital for day-to-day operations. It can include paying wages, buying inventory, or costs incurred for supplies and maintenance. The scheduled repayment for the loans is usually within a year.

A common type of short-term financing is a line of credit, which is secured with collateral. It is typically used with businesses struggling to keep a positive cash flow (expenses are higher than current revenues), such as start-ups.

Debt Financing Over the Long-Term

Businesses seek long-term debt financing to purchase assets, such as buildings, equipment, and machinery. The assets that will be purchased are usually also used to secure the loan as collateral. The scheduled repayment for the loans is usually up to 10 years, with fixed interest rates and predictable monthly payments.

Advantages of Debt Financing

Tax-deductible interest payments

Another benefit of debt financing is that the interest paid is tax-deductible. It decreases the company’s tax obligations. Furthermore, the principal payment and interest expense are fixed and known, assuming the loan is paid back at a constant rate. It allows for accurate forecasting, which makes budgeting and financial planning easier.

Preserve company ownership

The main reason that companies choose to finance through debt rather than equity is to preserve company ownership. In equity financing, such as selling common and preferred shares, the investor retains an equity position in the business. The investor then gains shareholder voting rights, and business owners dilute their ownership.

Debt capital is provided by a lender, who is only entitled to their repayment of capital plus interest. Hence, business owners are able to retain maximum ownership of their company and end obligations to the lender once the debt is paid off.

Disadvantages of Debt Financing

Adverse impact on credit ratings

If borrowers lack a solid plan to pay back their debt, they face the consequences. Late or skipped payments will negatively affect their credit ratings, making it more difficult to borrow money in the future.

The need for regular income

The repayment of debt can become a struggle for some business owners. They need to ensure the business generates enough income to pay for regular installments of principal and interest.

Many lending institutions also require assets of the business to be posted as collateral for the loan, which can be seized if the business is unable to make certain payments.

Potential bankruptcy

Agreeing to provide collateral to the lender puts their business assets at risk, and sometimes even their personal assets. Above all, they risk potential bankruptcy. If the business should fail, the debt must still be repaid.