Which form of financing needs to be repaid




















The cost of equity is the dividend payments to shareholders, and the cost of debt is the interest payment to bondholders. When a company issues debt, not only does it promise to repay the principal amount, it also promises to compensate its bondholders by making interest payments, known as coupon payments , to them annually. The interest rate paid on these debt instruments represents the cost of borrowing to the issuer.

The sum of the cost of equity financing and debt financing is a company's cost of capital. The cost of capital represents the minimum return that a company must earn on its capital to satisfy its shareholders, creditors, and other providers of capital.

A company's investment decisions relating to new projects and operations should always generate returns greater than the cost of capital.

If a company's returns on its capital expenditures are below its cost of capital, the firm is not generating positive earnings for its investors. In this case, the company may need to re-evaluate and re-balance its capital structure. The formula for the cost of debt financing is:. Since the interest on the debt is tax-deductible in most cases, the interest expense is calculated on an after-tax basis to make it more comparable to the cost of equity as earnings on stocks are taxed.

Both debt and equity can be found on the balance sheet statement. Some investors in debt are only interested in principal protection, while others want a return in the form of interest. The rate of interest is determined by market rates and the creditworthiness of the borrower. Higher rates of interest imply a greater chance of default and, therefore, carry a higher level of risk. Higher interest rates help to compensate the borrower for the increased risk. In addition to paying interest, debt financing often requires the borrower to adhere to certain rules regarding financial performance.

These rules are referred to as covenants. Debt financing can be difficult to obtain. However, for many companies, it provides funding at lower rates than equity financing, particularly in periods of historically low-interest rates.

Another advantage to debt financing is that the interest on the debt is tax-deductible. Still, adding too much debt can increase the cost of capital, which reduces the present value of the company. The main difference between debt and equity financing is that equity financing provides extra working capital with no repayment obligation. Debt financing must be repaid, but the company does not have to give up a portion of ownership in order to receive funds. Most companies use a combination of debt and equity financing.

Companies choose debt or equity financing, or both, depending on which type of funding is most easily accessible, the state of their cash flow , and the importance of maintaining ownership control.

One advantage of debt financing is that it allows a business to leverage a small amount of money into a much larger sum, enabling more rapid growth than might otherwise be possible.

Another advantage is that the payments on the debt are generally tax-deductible. Additionally, the company does not have to give up any ownership control, as is the case with equity financing. Because equity financing is a greater risk to the investor than debt financing is to the lender, debt financing is often less costly than equity financing. The main disadvantage of debt financing is that interest must be paid to lenders, which means that the amount paid will exceed the amount borrowed.

Payments on debt must be made regardless of business revenue, and this can be particularly risky for smaller or newer businesses that have yet to establish a secure cash flow. Debt financing includes bank loans; loans from family and friends; government-backed loans, such as SBA loans; lines of credit; credit cards; mortgages; and equipment loans. Debt financing can be in the form of installment loans , revolving loans , and cash flow loans. Installment loans have set repayment terms and monthly payments.

The loan amount is received as a lump sum payment upfront. These loans can be secured or unsecured. Revolving loans provide access to an ongoing line of credit that a borrower can use, repay, and repeat.

Credit cards are an example of revolving loans. Cash flow loans provide a lump-sum payment from the lender. Select basic ads. Create a personalised ads profile. Select personalised ads. Apply market research to generate audience insights.

Measure content performance. Develop and improve products. List of Partners vendors. Financing is the process of providing funds for business activities , making purchases, or investing. Financial institutions , such as banks, are in the business of providing capital to businesses, consumers, and investors to help them achieve their goals. The use of financing is vital in any economic system, as it allows companies to purchase products out of their immediate reach.

Put differently, financing is a way to leverage the time value of money TVM to put future expected money flows to use for projects started today. Financing also takes advantage of the fact that some individuals in an economy will have a surplus of money that they wish to put to work to generate returns, while others demand money to undertake investment also with the hope of generating returns , creating a market for money.

There are two main types of financing available for companies: debt financing and equity financing. Debt is a loan that must be paid back often with interest, but it is typically cheaper than raising capital because of tax deduction considerations. Equity does not need to be paid back, but it relinquishes ownership stakes to the shareholder. Both debt and equity have their advantages and disadvantages. Most companies use a combination of both to finance operations.

For example, the owner of a grocery store chain needs to grow operations. Companies like to sell equity because the investor bears all the risk; if the business fails, the investor gets nothing. At the same time, giving up equity is giving up some control. Equity investors want to have a say in how the company is operated, especially in difficult times, and are often entitled to votes based on the number of shares held.

So, in exchange for ownership, an investor gives his money to a company and receives some claim on future earnings. Some investors are happy with growth in the form of share price appreciation ; they want the share price to go up. Other investors are looking for principal protection and income in the form of regular dividends. Funding your business through investors has several advantages, including the following:. Similarly, there are a number of disadvantages that come with equity financing, including the following:.

Most people are familiar with debt as a form of financing because they have car loans or mortgages. Methods of obtaining financial capital may be more or less suitable for a firm, depending on the current stage of its life cycle. Firm Life Cycle : Firms progress through stages of development, indicated by their changing profits over time. In the first stage, a new company begins with the seed of an idea.

Its external financing needs EFN are high, since it needs money to develop but lacks retained earnings. These young firms are frequently financed through debt, acquiring loans from banks and acquaintances. They may also acquire seed money, a form of securities offering in which an investor usually friends, family, or angel investors purchases part of a business. The source of the financing may depend on the perceived riskiness and growth of the business.

Once a company has a successful strategy, it attempts to offer its products or services to potential customers—expanding first to other states and regions and then often internationally and globally.

Successful companies can turn in increasing earnings year after year, evidenced by the increasingly steep slope in the diagram. Firms may face an increase in competitors. If it fits the specifications for venture capital high growth potential, innovative product a VC firm may agree to finance the firm. It may also raise capital through equity financing. As it progresses through the growth stage, earnings begin to increase less rapidly.

At some point, the company may decide to go public, offering its stock to the general public on a security exchange as a means of equity financing. Eventually, all possible customers have the product or service. They may still buy parts or replace their product with newer models, etc, but growth slows.

If the firm has no new projects in the works, their EFN is quite low and internal funding is high. In fact, the firm may have so much in retained earnings that they cannot put all of it to productive use.

They can choose to finance operations by issuing bonds and equity. When the firm has reached the final stage, sales can stagnate or decline due to replacement by a better product or competitor. EFN declines further. They may choose to retire debt or repurchase stock, as significant external financing is no longer necessary. Venture capital abbreviated as VC is an attractive funding option for young companies with high growth potential, most often in high technology industries.

These new companies are unable to raise funds in more conventional ways like bank loans. Obtaining venture capital is different from raising debt or a loan from a lender. Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of the success or failure of a business.

Return is earned when the venture capitalist sells its shareholdings. This happens when the business goes public, issues shares to the general public through an Initial Public Offering IPO , or is acquired by a third party company. This increases the likelihood of reaching an IPO stage when valuations give high returns. Therefore, in addition to the initial financial funding, VC firms provide time, expertise and valuable business connections.

As these investments are illiquid and require years to reap full benefit, venture capitalists carry out due diligence, conducting very detailed investigations into the firms prior to investment. Venture investors may obtain special privileges that are not granted to holders of common stock, including:.

Initially, VC firms establish a fund which pools money raised from individuals, companies and other interested parties. This pooled investment vehicle is then used for investment in start-up enterprises. Structure of a Venture Capital Firm : The venture capital firm pools capital from investors and allocates it to venture efforts deemed worthy of investment.

Through informal and formal business networks, VC firms and entrepreneurs will meet to discuss the business plan and investment possibilities. In the most basic terms, debt financing takes the form of short-term or long-term loans that must be repaid over a specified period of time, usually with interest. Money is borrowed, and usually the borrower debtor gives the lender creditor a promissory note that obligates the debtor to pay back a certain defined amount at a particular and defined time in the future.

Bank loans as a means of financing : A promissory note dating to from the Imperial Bank of India, Rangoon, Burma for 20, Rupees, plus interest.

Debt financing usually takes the form of bank loans or bonds. Bonds are a debt security under which the issuer owes the holders a debt. Most corporate bonds are fixed-rate bonds, meaning that the interest rate stays the same until maturity.

Some use floating rates to determine the exact interest rate paid to bond holders. Other corporate bonds, called zero-coupons, make no regular interest payments at all, but investors still receive returns because these bonds are originally sold at a discount, and then are redeemed at par value upon maturity.

The interest that the firm will pay ultimately comes down to one factor: at what rate will investors believe the bonds are a good investment? Riskier investments will require compensation for the lender in the form of higher interest rates. Indicators for riskiness can include individual credit histories for a bank loan or bond rating by a credit rating company for corporate bonds.



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