Advantages and disadvantages of financing by equity and debt

Last updated: 25.03.2016

In business world, debt financing is paradoxically cheaper than from equity, because:

  • the cost of debt is interest, which is lower than the dividend (profit sharing) paid to shareholders – it is mainly due to the fact that equity holders are satisfied in case of liquidation either after debtholders or are not satisfied at all
  • the effect of tax shield
  • transaction costs for obtaining debt are usually lower than for equity
  • possibly also the effect of financial leverage

 

However, high level of debt is associated with the following risks:

  • lower creditworthiness - the company may not be able to meet its obligations in future or it will have problems to obtain a loan
  • high cost of debt (interest), which reduces the profitability of the company and thus also the dividend to shareholders
  • the risk of realization of assets held by the bank as a collateral

 

Equity is thus more expensive than debt capital and carries the following risks:

  • it may not be sufficient enough in the future and the company may not be able to secure other sources of funding
  • equity increases may bring more people with control which may threaten the flexibility in decision-making

 



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