Debt vs Equity Funding

The capital structure of the firm is the mix of debt and equity, the sum of which represents the value of the firm. New strategies and projects require investment in fixed assets and working capital. The company needs to decide on whether these projects are to be financed through debt, equity or hybrid financing, second tier debt, mezzanine funding, venture capital etc. which are combination of either debt, equity or both.

The optimum financing decision is based on the current capital structure of the firm and the new funding. Debt is cheaper than equity financing, as it provides a tax benefit (interest can be charged as an expense), but it does requires collateral and sometimes even directors covenants and personal guarantees, before it is made available. This represents both an opportunity and a risk to the firm’s shareholders.

Companies that are growing rapidly tend to use debt (particularly if they have strong balance sheets) as the return to equity shareholders increases if debt is used (the bank cannot ask for higher interest and a return just because the company is successful in tis strategies!), ergo any excess money stays with the shareholders. Conversely companies whose cash flows are under threat and/or where there is a possibility of a downside outcomes are at considerable risk, as the inability to service debt may result in the company being liquidated, even if the opportunity they have currently embarked on is a winner. The optimum debt position varies from industry to industry and depends on the circumstances of the firm.

Key benefits of operating at the optimum debt position are:

1. Taking on too much of debt places the company at risk. On the other hand not taking on cheaper debt and obtaining funding from equity partners reduces the return to the original shareholders. The optimum debt position ensures that the capital structure of the firm is designed to ensure the best mix of opportunity and risk;
2. Operating at the optimum debt position ensures that the company is able to use debt funding aggressively when growing, and that it is in a position to retire (or pay back its debt) when its revenues begin to plateau.