Debt Financing vs Equity Financing | Real Life Examples |

Debt Financing vs Equity Financing | Real Life Examples- a complete video on-

At first let’s know what are debt financing and equity financing then we’ll see an example how to work in real world let’s start with equity financing equity financing involves selling a portion of a company’s equity in return for capital for example the owner of company xy jet might need to raise capital to fund business expansion the owner decides to give up 10

Percent of ownership in the company and sell it to an investor in return for capital that investor now owns 10 percent of the company and has a voice in all business decisions going forward now let’s know what is debt financing money raised by the company in the form of borrowed capital is known as debt financing it represents that the company owes money towards

Another person or entity they are the cheapest source of finance as their cost of capital is lower than the cost of equity and preference shares funds raised through debt financing are to be repaid after the expiry of the specific term we have known water debt financing and equity financing now we should know that how they work in real world now let’s see an

Example suppose you run a small business and you need 40 000 usd of financing you can either take out a 40 000 bank loan at a 10 interest rate or you can sell a 25 stake in your business to your neighbor for 40 000 suppose your business earns a 20 000 profit during the next year if you took the bank loan your interest expense would be four thousand leaving you

With sixteen thousand in profit here don’t make mistake do not think that you will cut ten percent on your twenty percent twenty thousand profit now you have to cut that in person on the 40 000 that you took loan from the bank so 10 percent of 40 000 is 4 000 now you have to deduct this 4 000 from your 20 000 profit leaving you 16 000 in your hand conversely

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Had you used equity financing you would have zero debt and as a result no interest expense but would keep you only 75 percent of your profit because the other 25 percent being owned by your neighbor a shareholder therefore your personal profit would be 15 000 which is 75 percent of 20 000 and your 5000 would be yours in your shareholders hand from this example you

Can see how it is less expensive for you as the original shareholder of your company to issue debt as opposed to equity taxes make the situation even better if you had a debt since interest expenses deducted from earning before income taxes early fight thus acting as a tax shield although we have ignored taxes in the example for the sake of simplicity of course

The advantage of the fixed interest nature of date can also be an in disadvantage it presents a fixed expense thus increasing a company’s risk going back to our example suppose your company only earned 5000 during the next year instead of 20 000. with debt financing you still have the same 4000 of interest to pay this amount is fixed so you would have uh just

1000 in your hand right because you have to give that 4 000 interest right that’s your expense so you’re having 1 000 in your hand from that 5 000 profit with equity you again have no interest expense but this time you can only keep 75 percent right so every time you can keep 75 percent from the profit no matter how much the profit is now if you keep 75 percent

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Profit this will leave you with three thousand seven hundred and fifty dollar right so five thousand seventy five thousand of five thousand is seventy five percent of five thousand is three thousand seven hundred and fifty dollar here we can see that debt financing is more expensive that than equity financing now however if a company fails to generate enough

Cash the fixed cost nature of debt can prove to burdensome okay the basic idea represents the risk associated with debt financing now the question is which is cheaper debt or equity that is cheaper than equity for several reasons this the the primary reason for this is however that uh debt comes without tax this simply means that when we choose debt financing

It lowers our income tax because it helps remove the interest acquirable on the date on the earning before interest tax but if we look back our last example why we saw that equity financing is cheaper than debt financing so we can say that it depends sometimes equity financing can be even cheaper than debt financing but maximum time in general date financing

Is cheaper than equity financing you have to remember that too much debt financing and too much equity financing both can be expensive so let’s see how much debt financing can be expensive while the cost of debt is usually lower than the cost of equity for the reasons mentioned above taking on too much debt will cause the cost of debt to rise above the cost of

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Equity this is because the biggest factor influencing the cost of debt is the loan interest rate in the case of issuing bonds or the bond a bond coupon rate as a business as a business takes on more and more date its probability of defaulting on a state increases this is because more debt equals higher interest payments if a business experiences a slow sales

Period and cannot generate sufficient cash to pay its bondholders it may go into default therefore debt investors will demand a higher return from companies with a lot of debt in order to compensate them for the additional risk they are taking on this higher required return manifests itself in the form of higher interest rate now that we have understood why too

Much debt financing is expensive let’s know why too much equity financing is also expensive the cost of equity is generally higher than the cost of debt since equity investors take take on more rigs when purchasing a company stock as opposed to a company’s bond therefore an equity investor will demand higher returns an equity risk premium then the equivalent

Bond investor to compensate him or her for the additional risk that he or she is taking on when purchasing stock investing in stocks is riskier than investing in bonds because of a number of factors for example the stock market has a higher volatility of returns than the bond market stockholders have a lower claim on company assets in case of company default

Capital gains are not a guarantee dividends are decretionary for example a company has no legal obligations to issue dividends

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Debt Financing vs Equity Financing | Real Life Examples | By Business School of IR