Cost of debt vs cost of equity
Credit to Author: STEPHANIE DIMANDAL| Date: Fri, 21 Dec 2018 17:22:47 +0000
Every business needs working capital to support its operations. It is the lifeblood of business that entrepreneurs and shareholders source through debt financing or equity financing. As the funds flow into the business, it always comes with a cost – that of debt and equity.
A company enters into a debt financing typically in the form of a loan with an obligation to repay the funds at a specified future date. The repayable amount includes the interest. On the other hand, issuance of shares of a corporation, venture capital, and even the investments from family and friends in exchange of part ownership fall under equity financing. The ownership in the business is tantamount to the amount of investments. Both require a return for the lenders and investors, which is a cost to the business.
Debt financing
Generally, the cost of debt financing is relatively inexpensive compared to the cost of equity. Costs of debt such as interest, origination costs and other loan-related expenses impact profit or loss, which makes it more advantageous in reducing the tax liability. In addition to this, the risks associated with debt are lower due to contractual obligation. In the event of business closure, debt must be settled first before distributing any share to equity holders. It is also easier to quantify the cost of debt considering the opportunity costs of giving up future profits in equity financing.
Equity Financing
Costs associated in equity financing are dividends, profit-sharing and capital gains usually through stock appreciation. Equity financing becomes more complicated because it involves future cash flows and financial returns that vary depending on the agreement with investors. Giving up ownership goes with the bestowal of control as the investors will partake in the decision making and growth of the company. For instance, common shares issued by a corporation carry voting rights over major corporate decisions. In the reality TV show Shark Tank, entrepreneurs seek investments from a panel of investors called “Sharks” and try to get as much funding while foregoing as low a percentage of ownership as possible.
The Right Mix
In raising capital, it is important to have the right mix of debt and equity in order to achieve the optimal capital structure and minimize the cost of capital. Long-term and short-term company goals, financial condition and risks appetite are some of the factors that influence the optimization of these funds. In summary, the lower the cost of capital, the lower the opportunity costs, hence, the higher the value for the owners and shareholders of the company.
At First Circle, we finance businesses who need access to short-term credit to support the operations of their business. Having a financing partner would be a great help to meet these unforeseen funding requirements.
Stephanie Anne Dimandal is a certified public accountant currently working as the finance manager of First Circle, a fintech firm providing Purchase Order Financing and Invoice Financing to B2B companies in the Philippines. She graduated with a Bachelor’s Degree in Accountancy at the University of Santo Tomas. For questions and discussions about the topic of debt and equity financing, you may reach her at stephanie.dimandal@firstcircle.com
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