Debt and equity financing are two main instruments to fund a firm’s operations. They are tools that can be used in different combinations to achieve the goals of a firm. Debt refers to funds borrowed from creditors in exchange for interest payments and repayment of principal at some point in the future. Equity is invested in shares of stock by the owners and shareholders of a business corporation, and come with rights such as dividends paid to owners, either as cash or additional shares, and equity voting rights that affect how the company is run.
Although most businesses rely on both debt financing and equity financing, Fintalent’s debt & equity financing consultants argue that one strategy is not better than another. For example, using debt may seem the best approach when a firm issues bonds and needs to begin operations quickly. On the opposite end of the spectrum, if a firm is highly leveraged and has difficulty paying back its debts, equity financing may be better as an alternative method of raising funds.
Debt financing can also be risky due to its vulnerability to credit loss. In any finance business there is always risk associated with debt instruments such as bonds or loans that are part of a loan agreement or an instrument issued by a company instead of cash. The business will have some assets that it can use to collateralize these debts in case there is default on those debts.
A major difference between debt and equity financing is the cash flow from operations. Debt financing often has a predictable cash flow because it is secured by assets such as corporate loans or bonds issued by the company. Equity financing relies on profits to generate cash flows and therefore can be more risky than debt funds. With any investment strategy, you should always carefully consider your options.
Calculating Interest Rates on Debt Instruments
Although interest rates on different types of loans are usually different, the calculation method for them is usually the same. To find out the loan amount, the interest rate is added to principal, then divided by the number of remaining monthly payments. The result in dollars per month is called the effective annual interest rate (EAR).
Equity instruments such as preferred stock and common stock have different types of issues. In a preferred issue, you get additional shares of stock in exchange for your investment up to a certain dollar amount. In a dividend-paying common issue, you receive cash dividends by purchasing additional shares in an open market transaction. Both apply a financial return on investment to all classes of investor but they differ with regard to the return paid by investors.
A common way of analyzing the payback period of debt instruments is to calculate the effective annual interest rate (EAR) on a debt instrument given relevant parameters. This is achieved by dividing the total annual interest payment by the total cash flow (CFF).
The following table illustrates how to calculate EAR given three different cash flows. The company pays an interest rate of 10% per year, making an additional payment of $100,000 per year, and has a remaining term of four years with monthly payments of $10,000:
A different approach is to analyze an investment using a discounted cash flow model based on certain assumptions about future returns.
With the help of some simple math, you can determine the internal rate of return (IRR) which is the interest rate on a debt instrument that makes the Net Present Value (NPV) equal to zero. In this case, dividing D by E results in 0.05431848. This means that if we could invest $1 million at an annual rate of 5.43% for one year, our investment would be worth exactly $1 million at the end of the year. The IRR is also known as the discount rate when looking at present value, and IRR and NPV are known as cash flow techniques because they are based on cash flows rather than economic reality. In the graph, the IRR is a tangent line drawn from point A to point B.
Debt or Equity Financing?
The advantage to using a variety of financing strategies is that it can help businesses achieve long-term goals. Equity financing can be useful for start-up companies looking for investment funds that will provide equity capital and also increase the share value of their company if successful. Debt financing can help businesses get up and running quickly, as well as provide them a predictable cash flow in order to pay back creditors..
An important consideration that investors should consider when securing capital for their companies involves borrowing money from banks or through private loans. This process includes establishing certain terms and conditions which must be followed. For example, to obtain a loan from a bank, you will have to come up with financial statements for your business and for each source of financing that the company is considering. This process can be very time consuming and difficult and it is important that all parties involved adhere to the agreed upon terms and conditions. When obtaining support or funding through external sources, it is important that the investor or lender know something about the company’s financial standing, business plan and key personnel.
An important consideration when looking at any financing option should involve an analysis of cash flows. Debt instruments paid over time give investors a predictable cash flow into which they can invest. Equity securities provide a higher risk but the potential payout can be rewarding if the company goes on to record profits. If a business is unable to generate sufficient cash flows, it may not have access to enough capital in order to make debt payments. In this situation, equity financing may be necessary for a firm to stay afloat.
Summary
CFOs are responsible for making decisions regarding financing, asset management and cash flow from operations. Data about these areas is necessary for management to make sound business decisions and for investment to be successful. The process of critical decision making requires an understanding of the key issues involved in financing decisions, including understanding the cost of capital, the risk associated with different types of financing and the pros and cons of each type.
