Debt or Equity?

There are various types of capital that a company can raise, I was interested to read that debt is actually a cheaper form than equity!

Initially, I was under the impression that selling shares is a great form of capital as you’re getting investment into the company, whilst giving out a potentially tiny portion of ownership and not even a guarantee of a dividend payout! Companies don’t need to give out dividends consistently every year (as discussed in my dividends blog a few weeks back), sometimes it can be a better option to reinvest these funds into new projects with a positive NPV and create more shareholder value. Well, it actually turns out that this isn’t the best method of raising funds within a company.

Getting debt on the other hand, affects balance sheets more significantly I’d say. It also means that there are regular mandatory payouts to the lender, including interest charges. To me, I think I’d rather have investors! But the actual story is, companies prefer debt over equity as it is cheaper..

Although I said it could be a tiny proportion of ownership that is being given out to these new investors, it is still ownership, and with that comes rights. These owners then begin to have a say in the running of the company, to a certain extent, depending on the size of their ownership. When a company has to pay back a loan or other borrowings, it is a certain amount. With equity, the payouts are continuous during the length of the ownership. This could result in a lot higher payback than a debt version.

So, the positives of equity outweigh the positives of debt. Realistically, this becomes a cheaper option of finance for a company looking to increase capital.