Financing refers to the process of funding the purchase of assets, business activities, or investments. It is commonly achieved through two methods: debt and equity financing. Debt financing involves borrowing money that must be paid back with interest, usually requiring collateral. It is cheaper and allows the company to maintain control, but comes with the risk of default. Equity financing involves selling ownership in the company to investors without the obligation to pay back the investment. This method requires giving up control and ownership but offers more cash for operating expenses. To optimize the appropriate mix of debt and equity financing and to calculate overall financing costs, the weighted average cost of capital (WACC) can be used.
Financing is essential for businesses, consumers, and investors to achieve their financial goals. This article will focus on business financing, but the same principles apply to consumer financing. Financial institutions like banks play a vital role in providing capital to support business activities, investments, and purchases. By using financing, companies can buy goods or services that might have been too expensive otherwise. This allows them to grow and expand their operations while managing their cash flow. Without financing, businesses may struggle to acquire the resources they need to operate effectively and efficiently.
The importance of financing cannot be overstated in any economic system, as it allows for the effective utilization of the time value of money (TVM). Through financing, individuals and businesses can invest in projects today, using expected future cash flows. Additionally, financing takes advantage of the varying needs of individuals and businesses in an economy; some may have excess funds to invest, while others require capital to undertake investments. By creating a marketplace for money, financing facilitates the exchange of funds between these different groups, allowing for the efficient allocation of resources.
Financing: the basics
The process of obtaining the necessary funds for a purchase or to pay for business operations is commonly referred to as financing. The two primary types of financing are debt financing and equity financing.
With debt financing, a company borrows money from a lender and agrees to repay the loan with interest over time. This form of financing can be more affordable compared to other types of financing because of tax deductions.
In contrast, equity financing does not require repayment. Instead, the company issues ownership shares to shareholders, who then become partial owners of the company. Many companies use a combination of debt and equity financing to meet their financial needs.
What are the categories of financing?
When a company needs money to grow or invest, they can choose to take on debt or sell a stake in the company to investors. Equity financing means selling ownership, or equity, in the company to investors in exchange for their money.
This is a popular choice because investors take on all the risk; if the company fails, they lose their investment. However, giving up equity means giving up some control over the company. Investors may want to have a say in how the company is run, especially during tough economic times, and they may be entitled to vote based on their shares.
Some investors seek growth in the form of share price appreciation, while others want regular dividends for income.
Advantages of equity financing:
- You have no obligation to repay the investment if your business enters bankruptcy.
- You have more cash available for operating expenses.
- Investors have a long-term outlook and understand that building a business takes time.
Disadvantages of equity financing:
- When you raise equity financing, you’ll have to give up ownership of a portion of your company to your investor. This means you might have to give up 50% or more of your company, and the investor will take a share of your profits indefinitely.
- Additionally, you’ll have to consult with your investors before making important decisions, since they’ll have a say in how the company is operated.
Debt financing is a type of funding in which a business borrows money that it must repay with interest. Unlike equity financing, which involves giving up a share of ownership, debt financing allows the company to retain complete control over its operations.
Lenders may require collateral to secure a loan, which can be an asset such as property or equipment. This can make it easier for smaller businesses to access funding, especially if they lack a solid credit history. However, if the company fails to make payments, the lender can legally seize the collateral to recoup their losses.
While debt financing can provide a quick infusion of cash, it also requires the company to make regular payments, even during lean times. This can put a strain on the business’s cash flow and make it more challenging to weather economic downturns.
Advantages of debt financing:
- The lender has no control or ownership of your company.
- Monthly payment is a predictable expense for forecasting.
- The relationship with the lender ends after paying back the loan.
- Interest paid is tax-deductible.
Disadvantages of debt financing:
- Monthly debt payments assume consistent cash inflow, which may not always be the case for small or early-stage businesses.
- Obtaining debt financing can be difficult during economic recessions, even for highly qualified businesses.
What to consider when financing a business
The weighted average cost of capital (WACC) is a tool used to determine a company’s overall financing costs by taking into account the costs and proportions of each type of financing used.
Optimizing WACC is crucial for firms to determine the best blend of debt and equity financing, all while taking into account the risk of default and the willingness of owners to relinquish ownership. Debt financing is often favored because of its tax benefits and lower interest rates.
As a company accumulates more debt, it needs to take on equity financing to counterbalance its mounting credit risk. Investors may also prefer equity financing as it allows them to participate in a company’s future profitability and growth, something that debt instruments cannot provide. By finding the right mix of debt and equity financing, companies can minimize their cost of capital and maximize their value for shareholders.
WACC is calculated using the following formula:
E = Market value of the firm’s equity
D = Market value of the firm’s debt
V = E+D
Re = Cost of equity
Rd = Cost of debt
Tc = Corporate tax rate
Example of business financing
Imagine you run a small business and require $40,000. There are two options available to you: you can take out a bank loan at a 10% interest rate, or you can sell a 25% stake in your company to your neighbor for the same amount.
If your business generates a $20,000 profit in the next year, you would have an interest expense of $4,000 with the bank loan, leaving you with a $16,000 profit.
However, with equity financing, you wouldn’t have any debt or interest expense, but you would only retain 75% of the profit, as your neighbor now owns a 25% stake in the company. This means that your personal profit would be 75% of $20,000, or $15,000.
FAQ about business financing
Which type of financing is riskier: equity financing or debt financing?
Equity financing comes at a greater risk because if a company were to undergo bankruptcy, the creditors must be repaid in full before equity shareholders can receive anything.
Why would a company opt for equity financing?
Equity financing offers companies the opportunity to raise capital by selling ownership shares to investors. While this approach requires relinquishing some ownership control, it provides several advantages. Unlike debt financing, equity financing doesn’t require repayment of the money raised or making interest payments. This freedom enables companies to focus on building and expanding their businesses without the added financial pressure of debt.
Why would a company opt for debt financing?
Debt financing is a popular choice for companies since it allows them to retain ownership control while still securing necessary funds. Moreover, the interest paid on debts is often tax-deductible, providing added financial benefits. Compared to equity financing, debt financing is typically cheaper, as creditors have the right to claim a company’s assets in case of default. However, companies must make regular interest payments and eventually return the balance of the loan.
- Financing refers to the act of funding business activities and investments.
- There are two types of business financing: equity financing and debt financing.
- Equity financing has the advantage of not requiring repayment, but it carries more significant risks.
- Debt financing tends to be cheaper and offers tax benefits, but it comes with the risk of default and credit issues.
- To understand a firm’s overall financing cost, it helps to calculate its weighted average cost of capital (WACC).
View Article Sources
- Brealey, R. A., Myers, S. C., & Allen, F. (2016). Principles of corporate finance. McGraw Hill Higher Education.
- Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243.
- Brealey, R. A., Myers, S. C., & Marcus, A. J. (2018). Fundamentals of corporate finance. McGraw-Hill Education.
Allan Du is a personal finance writer passionate about helping people take control of their finances. Allan strives to present readers with the right knowledge and tools, so they can make informed decisions about their money and build wealth. When he is not writing about finance, Allan enjoys pursuing his other interests, including powerlifting, kickboxing, and investing. He is an active follower of economic and political trends, always keeping watch on the latest developments that could impact the financial world.