This week we are going to take a break from the economy and discuss more technical topics in the field. We all definitely heard of bonds, stocks, derivatives, and other investment instruments. However, you ever wonder if your investment is into the debt or credit of a company?
Let’s discuss something we’re most familiar with, which is debt. Debt is typically money that is due or owed to another person or party. The most common types of debts personal households have are credit card payments, medical bills, student loans, and various utility bills.
However, businesses have different forms of debt to finance their company. Just like our personal expenditures, businesses have to pay back the principal payment plus interest at maturity when they undergo debt.
There’s a lot of advantages of debt financing for a business. For instance, the lender of the loan has no control over your company’s operations. Once a borrower pays a loan, your communication with your financier can end. Additionally, debt financing is attractive because it is tax deductible. Therefore, company’s expenses can decrease with the tax shield.
However, there’s always negatives associated with the positives in the business world. When receiving debt financing, lenders always look at the company’s future ability to pay back the loan. The lender has to analyze if the borrower can pay back the loan when the economy hits the recession stage or undergoes a terrible business year. The inability for company to pay back its debt can damage their credit rating and hinder their ability to grow.
Now let’s talk the other phase of business financing: equity financing. Equity financing is the process of raising capital through the sale of ownership in the company. For many businesses, equity financing starts with venture capitals or angel investors. These are the people you see praised at Silicon Valley and the ABC TV show “Shark Tank.” However, many of your parents and you purchase Apple, Facebook, and Google stocks on investing portfolio. Believe it or not, you are performing equity financing.
Business owners desire to use equity financing to raise capital for a variety of reasons. For instance, equity investors take risk when purchasing shares of your company. So, business owners owe no future money because they have been given small ownership of the company already.
Unfortunately, there are downfalls with equity financing. As an illustration, businesses need to give a considerable percentage of their companies to raise enough funding for projects and operations. Therefore, equity investors take their share of the profits if the company continues to grow and becomes successful.
You must wondering which is the best way for businesses to finance their companies: debt or equity? All companies do a combination of both! Business management goal is to minimize the Weighted Average Cost of Capital. Below is the formula for WACC. This is an analysis tool used by companies to decide how much their company is spending to propel growth and profitability.
