The Equity- Debt Choice

One way to raise money for investment is through equity finance. Ordinary shares represent the equity share capital of the firm. As they say investors are the owners of the business who have the right to exercise control over the company, this method enables entrepreneurs to trade ownership of the business for financial backing (Tuchetti, 2014). However debt finance is different, as it has to be repaid with interest charged for the amount of cash being invested. The company will be obliged to maintain the repayment schedule through successful and tough years. Similarly, lenders of the firm have no official control over the business (NFIB, 2009). 

There are two main benefits of raising finance by selling shares rather than borrowing:

1.    There is usually no obligation to pay dividends
This means when losses are made, the company would not have the problem of finding money to pay dividends. Equity acts as a shock absorber under uncertain business scenarios or conditions. However, if a firm puts more reliance on debt, irrespective to whether the business is returning profits or making losses, it still puts undue pressure on profit margins and on cash flows (Peavler, 2014). 

2.    The capital used does not have to be repaid
Shares in the business do not have a redemption date. This is a date where the original sum invested is repaid to the shareholder. If a company was to use debt capital, the requirement to repay debt can put severe pressure and strain on cash flow. This can be severe up to the point where the firm is unable to survive. Therefore, by always having equity capital in the business it again is able to act as a shock absorber in bad times (Peavler, 2014).

 However, debt financing has many benefits including:

1. It is less expensive
This type of finance is less expensive than equity finance due to the lower rate of return required by finance providers, lower transaction costs for raising funds and also because of the tax deductibility of interest (Grossman & Livingstone, 2008). 

2. It is less risky
This method of finance is less risky because interest is paid out before dividends, so there is a greater certainty of receiving a return than there would be for equity holders. Equally, if the firm goes into liquidation the holders of debt type financial security are paid back before shareholders receive anything (Grossman & Livingstone, 2008). 

For example, Burrows (2013) from Bloomberg reported that Apple avoided as much as $9.2 billion in taxes by financing part of their $55 million stock buyback with debt rather than through offshore cash.  This shows that large corporations are able to take advantage of debt finance to achieve savings.


However, companies should take into consideration factors such as gearing. Increased levels of gearing within a business can increase the amount risk, which can have an affect on the shareholders decision to invest. For example, companies such as MF Global have drowned in debt due to $6.3billion European sovereign debt investment. This decision was advised by PwC, who committed to professional malpractice by offering “flatly erroneous” advice (Reuters, 2014).  Therefore, this decision led the company to go into bankruptcy. This example shows that too much is not good for a business. 

It is difficult to say which source of finance will be the best. Although debt finance is less risky and cheap, it may lead to greater risks in terms of problems for a company in the future.  Therefore, I would think the need to consider the right mix of debt and equity is important.