Advantages and disadvantages of financing by equity and debt

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