By Alex Gorgoni ‘17
When a business needs financing, two options are present: borrowing funds, or issuing a portion of its ownership to an investor (raising debt or issuing equity). Since both options are very fundamentally different, each has a different impact on the company’s cash flow and ultimate earnings.
So what is typically the “cheaper” option?
Simply put, when a company seeks capital from the bank, that company is agreeing to pay the stated interest rate and the principle amount of the loan at the end of the stated term period. When issuing equity, the business gives away a portion of the ownership of its company in exchange for capital (which dilutes the company’s existing ownership).
When a business is faced with an interest expense, that amount is tax detectable from the company’s pre-tax income. Therefore, the business is paying less in taxes at the end of each year, in turn, saving a certain amount of money from this “tax shield that is created.” In contrast, when equity is issued, there is no tax shield that is created – making debt in this scenario a “cheaper” alternative.
A loan is for a stated period of time. The bank may have a five-year tenor and collect the interest payments monthly, quarterly, or annually, over that stated time horizon. Once the loan’s interest and principle amount is paid off, the business borrowing the money no longer has any obligation to the bank. Alternatively, when a business issues equity, that portion of ownership the company previously controlled is gone forever. A debt obligation is for a finite period of time, whereas an equity issuance gives an investor ownership for an infinite period of time. Again, making debt over a longer period the less expensive alternative.
When issuing a portion of equity to an investor, that percentage of cash flow is forgone from the business at the end of the year. For example, if a company generates $100 and issues a 25% equity stake, $25 of the cash flow will go to the equity investor. Opposed to issuing equity, say the business took out a loan for $100. Even a fairly high one with an interest rate of 10%, the interest expense would only be $10. Again, it is evident that taking on the debt would be the cheaper alternative in this situation.
The reasons aforementioned give way to why companies often look at raising debt when they are in need of capital. As for a parting thought – when would raising debt start to cause problems for a company?