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Welcome to Alanis Business Academy. I'm Matt Alanis and this is An Introduction to Debt
and Equity Financing.
Finance is the function responsible for identifying the firm's best sources of funding as well
as how best to use those funds. These funds allow firms to meet payroll obligations, repay
long-term loans, pay taxes, and purchase equipment among other things. Although many different
methods of financing exist, we classify them under two categories: debt financing and equity
financing.
To address why firms have two main sources of funding we have take a look at the accounting
equation. The basic accounting equation states that assets equal liabilities plus owners'
equity. This equation remains constant because firms look to debt, also known as liabilities,
or investor money, also known as owners' equity, to run operations.
Now lets discuss some of the characteristics of debt financing. Debt financing is long-term
borrowing provided by non-owners, meaning individuals or other firms that do not have
an ownership stake in the company. Debt financing commonly takes the form of taking out loans
and selling corporate bonds. For information on bonds select the link above to access the
video: How Bonds Work.
Using debt financing provides several benefits to firms. First, interest payments are tax
deductible. Just like the interest on a mortgage loan is tax deductible for homeowners, firms
can reduce their taxable income if they pay interest on loans. Although deduction does
not entirely offset the interest payments it at least lessens the financial impact of
raising money through debt financing.
Another benefit to debt financing is that firm's utilizing this form of financing are
not required to publicly disclose of their plans as a condition of funding. The allows
firms to maintain some degree of secrecy so that competitors are not made away of their
future plans. The last benefit of debt financing that we'll discuss is that it avoids what
is referred to as the dilution of ownership. We'll talk more about the dilution of ownership
when we discuss equity financing.
Although debt financing certainly has its advantages, like all things, there are some
negative sides to raising money through debt financing. The first disadvantage is that
a firm that uses debt financing is committing to making fixed payments, which include interest.
This decreases a firm's cash flow. Firms that rely heavily in debt financing can run into
cash flow problems that can jeopardize their financial stability.
The next disadvantage to debt financing is that loans may come with certain restrictions.
These restrictions can include things like collateral, which require the firm to pledge
an asset against the loan. If the firm defaults on payments then the issuer can seize the
asset and sell it to recover their investment. Another restriction is a covenant. Covenants
are stipulations or terms placed on the loan that the firm must adhere to as a condition
of the loan. Covenants can include restrictions on additional funding as well as restrictions
on paying dividends.
Now that we have reviewed the different characteristics of debt financing lets discuss equity financing.
Equity financing involves acquiring funds from owners, who are also known as shareholders.
Equity financing commonly involves the issuance of common stock in public and secondary offerings
or the use of retained earnings. For information on common stock select the link above to access
the video: Common and Preferred Stock.
A benefit of using equity financing is the flexibility that it provides over debt financing.
Equity financing does not come with the same collateral and covenants that can be imposed
with debt financing. Another benefit to equity financing also does not increase a firms risk
of default like debt financing does. A firm that utilizes equity financing does not pay
interest, and although many firm's pay dividends to their investors they are under no obligation
to do so.
The downside to equity financing is that it produces no tax benefits and dilutes the ownership
of existing shareholders. Dilution of ownership means that existing shareholders percentage
of ownership decreases as the firm decides to issue additional shares. For example, lets
say that you own 50 shares in ABC Company and there are 200 shares outstanding. This
means that you hold a 25 percent stake in ABC Company. With such a large percentage
of ownership you certainly have the power to affect decision-making. In order to raise
additional funding ABC Company decides to issue 200 additional shares. You still hold
50 shares in the company, but now there are 400 shares outstanding. Which means you now
hold a 12.5 percent stake in the company. Thus your ownership has been diluted due to
the issuance of additional shares. A prime example of the dilution of ownership occurred
in in the mid-2000's when Facebook co-founder Eduardo Saverin had his ownership stake reduced
by the issuance of additional shares.
This has been An Introduction to Debt and Equity Financing. For access to additional
videos on finance be sure to subscribe to Alanis Business Academy and also remember
to like and share this video with your friends.
Thanks for watching.
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