Debt or Equity Financing: What's the Best Option?

Debt or equity financing? Learn about their advantages and disadvantages so you can make an informed decision about what's best for your business.

Debt or Equity Financing: What's the Best Option?

Since debt is almost always cheaper than equity, debt is almost always the answer. Debt is more affordable than stocks because the interest paid on debt is tax-deductible and the expected returns of lenders are lower than those of stock investors (shareholders). Both the risk and the potential return on debt are lower. Depending on your business and performance, debt may be more cost-effective than capital, but the opposite can also be true.

If your business doesn't make a profit and you close, then, in essence, your equity funding doesn't cost you anything. If you apply for a small business loan through debt financing and you don't get benefits, you'll still have to pay back the loan plus interest. In this case, debt financing would be more expensive. However, if your company sells for millions of dollars, the amount you pay to shareholders could be much higher than if you had kept that property and simply paid back a loan. Shareholders buy shares with the understanding that they then own a small share in the business.

The company is then indebted to shareholders and must generate consistent profits to maintain a healthy stock valuation and pay dividends. Because equity financing represents a greater risk for the investor than debt financing for the lender, the cost of capital is often higher than the cost of debt. The advantage of debt financing is that it allows a company to convert a small amount of money into a much larger sum, allowing for faster growth than would otherwise be possible. Capital can also provide a basis for supporting debt and increasing a company's ability to raise additional funds. Most companies use a combination of debt and equity financing, but both have some clear advantages.

Debt financing sometimes entails restrictions on the company's activities that may prevent it from taking advantage of opportunities outside the scope of its main activity. Creditors welcome a relatively low debt-to-equity ratio, which benefits the company if it needs access to additional debt financing in the future. To obtain this capital, ABC Company decides to do so through a combination of equity financing and debt financing. Equity and debt financing, alone or in combination, are useful strategies for providing financing for working capital, growth, and mergers and acquisitions. Securing equity financing may be a simpler process than debt financing, but it is necessary to have an extremely attractive product or financial projections, in addition to being able to give up part of the company and, often, a good dose of control. During the 1970s, financial managers who were struggling to increase working capital due to inflation and coping with the rising cost of new plants and equipment used every new dollar of capital to accumulate a debt of about $3 and a half. On the contrary, if they decided to use only debt financing, their monthly expenses would be higher, leaving less cash available for other purposes as well as a greater debt burden that they would have to pay with interest.

Finding the combination of debt and equity financing that generates the best financing at the lowest cost is a basic principle of any prudent business strategy. The WACC multiplies the percentage costs of debt after accounting for the corporate tax rate and capital in each proposed financing plan by a weighting equal to the proportion of total capital represented by each type of capital. The downside of debt financing is that lenders require interest payments, which means that the total amount repaid exceeds the initial sum. This allows companies to determine what levels of debt and equity financing are most profitable.