Different financing methods companies can use and then argued that their choice depends on the

costs and benefits of debt financing and the firm’s life cycle. For example, whereas startup
companies are likely to be financed with private personal funds, making their leverage low,
mature companies tend to have high leverage because they are able to mitigate the costs of debt
and gain from the tax benefits. In addition to these factors, in practice firms may choose their
financing mix by mimicking comparable firms, or they may adopt the average level of debt of all
the companies in their industry. These methods are not highly recommendable as they may result
in a suboptimal choice. In other cases they follow a financing hierarchy, where retained earnings
are the preferred option, followed by external financing in the form of debt, and then equity. This
preference is driven by the transaction and monitoring costs.

Types of Financing
There are two financing methods that companies can use: debt, and equity.

Debt Financing
Debt financing ranges from simple bank debt to commercial paper and corporate bonds. It is a
contractual arrangement between a company and an investor, whereby the company pays a
predetermined claim (or interest) that is not a function of its operating performance, but which is
treated in accounting standards as an expense for tax purposes and is therefore tax-deductible.
The debt has a fixed life and has a priority claim on cash flows in both operating periods and
bankruptcy. This is because interest is paid before the claims to equity holders, and, if the
company defaults on interest payments, it will be declared bankrupt, its assets will be sold, and
the amount owed to debt holders will be paid before any payments are made to equity holders.

Equity Financing
Equity financing includes owners’ equity, venture capital (equity capital provided to a private
firm in exchange for a share ownership of the firm), common equity, and warrants (the right to
buy a share of stock in a company at a fixed price during the life of the warrant). Unlike debt, it
is permanent in the company, its claim is residual and does not create a tax advantage from its
payments as dividends are paid after interest and tax, it does not have priority in bankruptcy, and
it provides management control for the owner.

Benefits of Debt
There are two main advantages of debt financing: taxation, and added discipline.
Taxation: Since the interest on debt is paid before taxation, whereas dividends paid to equity
holders are usually paid from profit after tax, the cost of debt is substantially less than the cost of
equity. This tax-deductibility of interest makes debt financing attractive. Suppose that the debt of
a company is $100 million and the interest rate is 10%. Every year the company pays interest of
$10 million. Suppose that the corporation tax rate is 30%. If the company does not pay tax, its
interest will be $10 million and the cost of debt will be 10%. However, if the company is able to
deduct the tax on this $10 million from its corporation tax payment, then the company saves $10
million × 30% = $3 million in tax payments per year, making the effective interest payment only
$7 million. If the debt is permanent, every year the company will have a $3 million tax saving,
referred to as a tax shield. We can compute the present value (PV) by discounting annual value
by the cost of debt, as follows:
PV of tax shield = kd × D × tckd = D × tc where kd is the cost of debt, D is the amount of debt,
and the product of kd and D gives the amount of the interest charge. tc is the corporation tax rate.
We simplify the ratio by kd to obtain the present value of the tax shield as the product of the
amount of debt and the corporation tax rate. Thus, the value of a company that is financed with
debt and equity (such a company is referred to “levered”) should be equal to its value if it is
financed only with equity plus the present value of the tax shield. We can write this value as:
Value of levered firm with debt D =Value of nonlevered firm + D × tc
These arguments suggest that the after-tax cost of debt can be computed as 10% × (1 # 30%) =
7%.
Added discipline: In practice, the managers are not the owners of the company. This so-called
separation of managers and stockholders raises the possibility that managers may prefer to
maximize their own wealth rather that of the stockholders. This is referred to as the agency
conflict. In general, debt may make managers more disciplined because debt requires a fixed
payment of interest, and defaulting on such payments will lead a company to bankruptcy.

Disadvantages of Debt Financing

The disadvantages of borrowing money for a small business may be great. You may have large
loan payments at precisely the time you need funds for start-up costs. If you don't make loan
payments on time to credit cards or commercial banks, you can ruin your credit rating and make
borrowing in the future difficult or impossible. If you don't make your loan payments on time to
family and friends, you can strain those relationships.

For a new business, commercial banks may require you to pledge your personal assets before
they will give you a loan. If your business goes under, you will lose your personal assets.

Any time you use debt financing, you are running the risk of bankruptcy. The more debt
financing you uses, the higher the risk of bankruptcy. Calculate the debt to equity ratio to
determine how much debt your firm is in compared to its equity.

Some will tell you that if you incorporate your business, your personal assets are safe. Don't be
so sure of this. Even if you incorporate, most financial institutions will still require a new
business to pledge business or personal assets as collateral for your business loans. You can still
lose your personal assets.

Which is best; debt or equity financing? It depends on the situation. Your financial capital,
potential investors, credit standing, business plan, tax situation, the tax situation of your
investors, and the type of business you plan to start all have an impact on that decision. The mix
of debt and equity financing that you use will determine your cost of capital for your business.

Advantages and disadvantages of equity finance

Equity finance can sometimes be more appropriate than other sources of finance, eg bank loans,
but it can place different demands on you and your business.
The main advantages of equity finance are:
  The funding is committed to your business and your intended projects. Investors only
realise their investment if the business is doing well, eg through stock market flotation or
a sale to new investors.
 The right business angels and venture capitalists can bring valuable skills, contacts and
experience to your business. They can also assist with strategy and key decision making.
 In common with you, investors have a vested interest in the business' success, ie its
growth, profitability and increase in value.
 Investors are often prepared to provide follow-up funding as the business grows.
The principal disadvantages of equity finance are:
 Raising equity finance is demanding, costly and time consuming. Your business may
suffer as you devote time to the deal. Potential investors will seek background
information on you and your business - they will closely scrutinise past results and
forecasts and will probe the management team. However, many businesses find this
discipline useful regardless of whether or not they actually receive any funding.
 Depending on the investor, you will lose a certain amount of your power to make
management decisions.
 You will have to invest management time to provide regular information for the investor
to monitor.
 At first you will have a smaller share in the business - both as a percentage and in
absolute monetary terms. However, your reduced share may become worth a lot more in
absolute monetary terms if the investment leads to your business becoming more
successful.
 There can be legal and regulatory issues to comply with when raising finance, eg when
promoting investments.

ADVANTAGES OF DEBT COMPARED TO EQUITY

 Because the lender does not have a claim to equity in the business, debt does not dilute
the owner's ownership interest in the company.

 A lender is entitled only to repayment of the agreed-upon principal of the loan plus
interest, and has no direct claim on future profits of the business. If the company is
successful, the owners reap a larger portion of the rewards than they would if they had
sold stock in the company to investors in order to finance the growth.

 Except in the case of variable rate loans, principal and interest obligations are known
amounts which can be forecasted and planned for.

 Interest on the debt can be deducted on the company's tax return, lowering the actual cost
of the loan to the company.

 Raising debt capital is less complicated because the company is not required to comply
with state and federal securities laws and regulations.
  The company is not required to send periodic mailings to large numbers of investors,
hold periodic meetings of shareholders, and seek the vote of shareholders before taking
certain actions.
DISADVANTAGES OF DEBT COMPARED TO EQUITY
 Unlike equity, debt must at some point be repaid.

 Interest is a fixed cost which raises the company's break-even point. High interest costs
during difficult financial periods can increase the risk of insolvency. Companies that are
too highly leveraged (that have large amounts of debt as compared to equity) often find it
difficult to grow because of the high cost of servicing the debt.

 Cash flow is required for both principal and interest payments and must be budgeted for.
Most loans are not repayable in varying amounts over time based on the business cycles
of the company.

 Debt instruments often contain restrictions on the company's activities, preventing

management from pursuing alternative financing options and non-core business
opportunities.

 The larger a company's debt-equity ratio, the more risky the company is considered by
lenders and investors. Accordingly, a business is limited as to the amount of debt it can
carry.

 The company is usually required to pledge assets of the company to the lender as
collateral, and owners of the company are in some cases required to personally guarantee
repayment of the loan.

Financing Choices and a Firm’s Life Cycle

Although companies may prefer to use internal financing to minimize the issuance (transaction)
costs, the trend in financing depends critically on the firm’s life cycle.

Start-ups are small, privately owned companies. They are likely to be financed by owners’ funds
and bank borrowings. Their funding needs are high, but their ability to raise external funding is
limited because they do not have sufficient assets to offer as security to finance providers. They
will try to seek private equity funding. Their long-term leverage is likely to be low as they are
mainly financed with short-term debt.

Expanding companies are those that have succeeded in attracting customers and establishing a
presence in the market. They are likely to be financed by private equity and/or venture capital in
addition to owners’ equity and bank debt. Their level of debt is low and they have more short-
term than long-term debt in their capital structure.
High-growth companies are likely to be publicly traded, with rapidly growing revenues. They
will issue equity in the form of common stock, warrants, and other equity options, and probably
convertible debt. They are likely to have a moderate leverage.

Mature companies are likely to finance their activities by internal financing, debt, and equity.
Their leverage is likely to be relatively high but will depend on the costs and benefits of debt and
their fundamental factors, such as business risk and taxation.

The choice of financing is strategic and involves the following issues:

 Both low- and high-debt financing are suboptimal. Companies should aim for the most
advantageous level of debt financing, whereby the costs are minimized and the benefits
are maximized.
 The costs of debt include a greater probability of bankruptcy, an increase in the agency
conflicts between managers and bondholders, a loss of future financial flexibility
(including the availability of collateral assets), and information asymmetry costs.
 The benefits relate mainly to tax shields and the added discipline to mitigate the agency
conflicts between stockholders and managers.
 This equilibrium applies primarily to mature companies. Start-ups and growth companies
are likely to have lower leverage as their borrowing capacity is low. It also applies to
companies that normally pay dividends and do not accumulate cash for reinvestment in
order to avoid the need to raise external financing.