Debt Vs. Equity Finance
Corporations finance themselves by either taking out loans or issuing equity to investors. Financial managers coordinate corporate finance that meets business objectives by evaluating the distinct advantages of debt and equity. Meanwhile, investors analyze corporate balance sheets while appraising the viability of an investment. Businesses that demonstrate a strong command of corporate finance strategy are better positioned to grow profits and returns for investors.
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Identification
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Corporations sell equity, or ownership stakes, to investors in the form of shares of stock. Larger, publicly traded companies increase access to capital through initial public offerings (IPOs), where investors buy into the firm. Common stock carries claims to the assets and profitability of the corporation, alongside voting rights. Shareholders vote to elect a board of directors, who in turn hire management to run the company. Meanwhile, creditors loaning money to the business supply debt financing. In exchange, the business makes interest payments on these loans. Creditors have no say in business operations, but carry asset claims above shareholders. This means that in the event of bankruptcy, creditors are paid off first.
Features
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Debt financing may be categorized further into mortgages, commercial paper, certificates of deposit and bonds. All debt financing works by making interest payments in exchange for carrying loan principal for a set period. Further, debt financing may be either secured or unsecured. Unsecured debt relies solely upon good faith within the company to make payments. Secured loans, however, are backed by property. Mortgages identify secured loans, where creditors carry rights to seize real estate to make good on credit defaults. Creditors demand higher interest rates for loaning money to riskier businesses and projects. Stocks and bonds fluctuate in value according to business profitability. Stock prices are associated with market valuations for the entire firm, because theoretically you will own the whole company by purchasing all of its stock.
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Considerations
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Financial managers recognize that corporate profits are affected by the costs of financing. Corporations pay interest on bonds and dividends on stocks. Interest payments are tax-deductible expenses, which are required to meet loan terms. Conversely, dividends are not tax-deductible because they are paid out of net income to investors. Common stock shareholders cannot force corporations to make dividend payments. Shareholders, however, are attracted to businesses that employ intelligent dividend strategies. Mature companies that lack growth opportunities should return earnings to shareholders with larger dividend payments. Meanwhile, retaining earnings to finance expansion, rather than paying out dividends, better serves growing businesses.
Benefits
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Issuing common stock enables the corporation to access capital without being forced to meet interest expense obligations. Financial managers may also use common stock as currency to buy out other firms. In comparison, debt provides access to capital without ceding control. Shareholders own the company, not creditors.
Risks
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All financial transactions carry risks. Corporations issuing equity may be targets for takeovers that adversely affect future earnings. Investors can control the business by purchasing more than 50 percent of its outstanding shares. Of course, debt financing increases expenses, alongside the risks of default and business failure.
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References
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