Why Debt Is Cheaper than Equity. An essential contributor to the success of every business establishment is Finance. This has to do with raising funds to take care of business expenditures. It is believed that cash is the lifeblood of a business, and small, and large companies require it for growth or expansion at some point in their life cycle.
A start-up company requires capital to run its business activities, and a growing company needs funds to support its growth. Given debt and equity as the primary sources of business finance, deciding which one to adopt is crucial.
This article focuses on the source of business finance that requires a lower cost or is cheaper to raise.
What Is Debt Financing?
Put, debt financing means borrowing money to fund a company’s operations with the promise to pay back the borrowed funds, known as the principal, at a later date following the terms of the agreement. Throughout borrowing the money, the company pays interest.
Debt financing can come from various sources, such as traditional bank loans, government loans, business loans, trade credit, bonds, asset lenders, credit cards, personal loans, lines of credit, installment purchases, etc. However, bank loans are the most common form of debt financing.
What Is Equity Financing?
This has to do with the raising of funds through the sales of a company’s shares. The Shareholders are the equity investors who purchase these shares in exchange for cash. These investors are entitled to a portion of the company’s profit, called dividends, regularly throughout the company’s existence.
The sources of equity financing include; Retained earnings, Corporate and Institutional investors, Venture capital firms, Corporate investors, Equity crowdfunding, Initial public offerings, etc. An initial public offering is the most common type of equity financing.
What Makes Debt A Cheaper Source Of Finance?
We can draw from the definition above that debt and equity financing provide different means through which a company can access funds.
But, It is important to note that these means are external and have an individual cost attached. The primary reasons why companies might decide to finance their operations with debt rather than equity are described as follows:
1. There is a limit on the amount required to pay back to debt investors
The cost of debt is limited to the period during which the loan is outstanding or its useful life. Although the firm has a primary duty to pay back the loan, once the entire sum has been repaid, the firm is released from any further obligations. In contrast to equity financing, ownership of the business is divided among several shareholders who provide financial support to the business.
This requires the company to distribute a share of its profits to equity investors. This signifies an unlimited time. Also, a firm that generates more profit over time would incur more costs on dividend payments.
In other words, a business owner should finance his business operation with debt and pay interest, enabling him to keep the profit earned.
2. The Interest Paid on Debt is Tax Deductible
A company’s profit is subject to tax, subtracted from its Profit Before Tax (PBT) to arrive at its profit for the year. With debt financing, the interest on the loan amount is an allowable tax expense that reduces a company’s income tax.
The higher the profit a firm earns, the higher the tax it pays, and vice versa. Expenses typically decrease a firm’s gain, and since interest expenses are deducted from Profit Before Interest and Taxes (PBIT), the result is a lower profit before taxes.
This profit will be subject to lesser taxation than a profit free of interest expense. This gives the borrowing company a tax benefit, making debt financing a more cost-effective source of finance for a corporation, unlike equity financing, which has no interest.
3. Absence of Dilution of Ownership
A business owner who uses debt to fund his operations would have autonomy in the management of his company, as loan investors have no say on how the company is run.
They are simply interested in your ability to fulfill your debt obligations. This is not true for equity investors because they have a controlling interest in the company’s operations as shareholders. They are appointed to the company’s board of directors and have a stake in its ownership, which gives them the right to participate in decision-making.
A company with multiple shareholders will experience shared decision-making, which could lead to conflicts of interest. This is a cost associated with equity financing.
4. Easier Accessibility
A business owner can borrow money more quickly through debt financing than through equity financing. This is so that the time required to manage the firm can be saved via debt financing.
Debt financing has fewer restrictions since, unlike equity, it can be obtained from various sources and with a wide range of options. Equity-based financing for businesses requires more time. This is due to the fact that raising money through issuing shares requires a lot of work, such as making numerous phone calls, delivering sales pitches, attending meetings, etc.
Debt financing is a less expensive kind of funding since debt investors are not interested in monitoring every business decision you make or every business strategy you employ.
What Matters In Decision Making?
Choosing between debt and equity financing will entirely depend on your company and the stage of your startup process. Your choice of financing option will be heavily influenced by factors including current and projected profitability, ownership and control requirements, and if your company qualifies for the loan options.
However, a company should consider using debt to finance its business if it seeks a cheaper source of finance. Also, If your business develops to the point where it may be sold for a huge sum, debt may be far less expensive than equity. Then, instead of having to distribute the percentage share to your shareholders, you just pay off the debt while maintaining full ownership.
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