A firm's capital structure is made up of equity and debt. The cost of equity is the dividend payments to shareholders, and the cost of debt is the interest payment to bondholders. When a company issues debt, not only does it promise to repay the principal amount, it also promises to compensate its bondholders by making interest payments, known as coupon payments , to them annually. The interest rate paid on these debt instruments represents the cost of borrowing to the issuer.
The sum of the cost of equity financing and debt financing is a company's cost of capital. The cost of capital represents the minimum return that a company must earn on its capital to satisfy its shareholders, creditors, and other providers of capital. A company's investment decisions relating to new projects and operations should always generate returns greater than the cost of capital.
If a company's returns on its capital expenditures are below its cost of capital, the firm is not generating positive earnings for its investors. In this case, the company may need to re-evaluate and re-balance its capital structure. The formula for the cost of debt financing is:.
Since the interest on the debt is tax-deductible in most cases, the interest expense is calculated on an after-tax basis to make it more comparable to the cost of equity as earnings on stocks are taxed. Both debt and equity can be found on the balance sheet statement. Some investors in debt are only interested in principal protection, while others want a return in the form of interest. The rate of interest is determined by market rates and the creditworthiness of the borrower.
Higher rates of interest imply a greater chance of default and, therefore, carry a higher level of risk. Higher interest rates help to compensate the borrower for the increased risk. In addition to paying interest, debt financing often requires the borrower to adhere to certain rules regarding financial performance. These rules are referred to as covenants. Debt financing can be difficult to obtain.
However, for many companies, it provides funding at lower rates than equity financing, particularly in periods of historically low-interest rates. Another advantage to debt financing is that the interest on the debt is tax-deductible.
Still, adding too much debt can increase the cost of capital, which reduces the present value of the company. The main difference between debt and equity financing is that equity financing provides extra working capital with no repayment obligation.
Debt financing must be repaid, but the company does not have to give up a portion of ownership in order to receive funds. Most companies use a combination of debt and equity financing. Companies choose debt or equity financing, or both, depending on which type of funding is most easily accessible, the state of their cash flow , and the importance of maintaining ownership control.
One advantage of debt financing is that it allows a business to leverage a small amount of money into a much larger sum, enabling more rapid growth than might otherwise be possible. Another advantage is that the payments on the debt are generally tax-deductible. Additionally, the company does not have to give up any ownership control, as is the case with equity financing.
Because equity financing is a greater risk to the investor than debt financing is to the lender, debt financing is often less costly than equity financing. The main disadvantage of debt financing is that interest must be paid to lenders, which means that the amount paid will exceed the amount borrowed. Payments on debt must be made regardless of business revenue, and this can be particularly risky for smaller or newer businesses that have yet to establish a secure cash flow.
Debt financing includes bank loans; loans from family and friends; government-backed loans, such as SBA loans; lines of credit; credit cards; mortgages; and equipment loans.
Debt financing can be in the form of installment loans , revolving loans , and cash flow loans. Installment loans have set repayment terms and monthly payments. The loan amount is received as a lump sum payment upfront. These loans can be secured or unsecured. Revolving loans provide access to an ongoing line of credit that a borrower can use, repay, and repeat.
Credit cards are an example of revolving loans. Cash flow loans provide a lump-sum payment from the lender. Payments on the loan are made as the borrower earns the revenue used to secure the loan. Merchant cash advances and invoice financing are examples of cash flow loans. Yes, loans are the most common forms of debt financing.
Debt financing can be both good and bad. If a company can use debt to stimulate growth, it is a good option. However, the company must be sure that it can meet its obligations regarding payments to creditors.
A company should use the cost of capital to decide what type of financing it should choose. Most companies will need some form of debt financing. Additional funds allow companies to invest in the resources they need in order to grow. Small and new businesses, especially, need access to capital to buy equipment, machinery, supplies, inventory, and real estate. The main concern with debt financing is that the borrower must be sure that they have sufficient cash flow to pay the principal and interest obligations tied to the loan.
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Banks, pension funds and individuals all buy bonds in return for an interest on the bond. In some circumstances, debt can be financed by the Central Bank printing money and buying bonds itself. Responding to a comment on UK National Debt ,.
It used to be the Bank of England who was responsible for selling the government debt to the private sector. But, in , the government transferred the operation to the UK debt management office, a branch of the HM Treasury.
The national debt is mostly financed through the sale of government bonds, bills and gilts. These Government bonds tend to be bought by financial institutions such as investment trusts and pension funds.
They are bought because they provide a secure investment with reasonable rates of interest. If the government had to borrow a lot then the interest rate on bonds may be forced upwards to attract enough people to buy the bonds. The bonds and gilts may be anything from 3 months to 30 years. In the First World War, the Government borrowed by selling open ended stocks; some are still outstanding though relatively insignificant. The Government have to pay interest to those who buy the bonds and bills.
Is that the private sector in the UK alone, or do financial institututions in other countries also buy UK government bonds? It was split out by Gordon Brown in Google their accounts. Its fascinating. I am a normal working man aged 40 working 5 days a week and wondering if this national debt is likeley to lead to higher interest rates? Perhaps the austerity hit British Public should not be too worried about paying this particular portion of the debt.
Nice fantasy. All money is debt so we may as well call government issued money debt. In the First World War, the Government borrowed by selling open ended stocks; some are still outstanding though relatively insignificant The Government have to pay interest to those who buy the bonds and bills.
Thanks Anthony! Pingback: Who Lends the Government Money? Economics Blog. We use cookies on our website to collect relevant data to enhance your visit.
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