Growth Debt Financing

Growth Debt Financing
Growth Debt Financing

When a company sells debt instruments to people and institutional investors, it raises money for working capital or capital expenditures. Individuals or institutions become creditors in exchange for lending money and obtain a guarantee that the principal and interest on the loan will be repaid. Another approach to raise money in the debt markets is to sell stock in a public offering, which is known as equity financing.

When a firm needs money, it has three options: sell shares, take on debt, or employ a combination of the two. The term “equity” refers to a company’s ownership share. It offers the shareholder a claim on future earnings without requiring repayment. Equity holders are the last to get money if the company goes bankrupt.

Debt financing is when a firm sells fixed income products to investors, such as bonds, bills, or notes, to raise the funds it needs to grow and extend its operations. When a firm issues a bond, the bond is purchased by lenders, who are either retail or institutional investors who provide debt financing to the company.

The principal of the investment loan, also known as the loan amount, must be repaid at a later period. Lenders have a larger claim on any liquidated assets than shareholders if the company goes bankrupt.

Cost of Debt

The capital structure of a company is made up of equity and debt. Dividend payments to shareholders are the cost of equity, whereas interest payments to bondholders are the cost of debt. When a firm issues debt, it not only commits to repaying the principal but also compensates bondholders by making periodic interest payments, often known as coupon payments. The cost of borrowing for the issuer is represented by the interest rate paid on these debt instruments.

A company’s cost of capital is equal to the total of its equity and debt financing costs. The cost of capital is the minimum rate of return a firm must achieve on its capital to satisfy its shareholders, creditors, and other capital suppliers. The returns on new projects and operations should always be greater than the cost of capital for a company’s investment decisions.

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:

KD = Interest Expense x (1 – Tax Rate)

where KD = cost of debt

Measuring Debt Financing

The debt-to-equity ratio (D/E) is a metric used to evaluate and analyze how much of a company’s capital is financed with debt. The D/E ratio is $2 billion / $10 billion = 1/5, or 20%, if total debt is $2 billion and total shareholders’ equity is $10 billion.It means that for every $1 of loan funding, $5 of equity is available. A low D/E ratio is preferable to a high one in general, while some industries have a higher debt tolerance than others. The balance sheet statement includes both debt and equity.

Debt Financing vs. Interest Rates

Some debt investors are primarily concerned with protecting their principal, while others want a return in the form of interest. The rate of interest is influenced by market rates as well as the borrower’s creditworthiness. Higher interest rates suggest a higher likelihood of default and, as a result, a higher level of risk. Higher interest rates assist the borrower in compensating for the higher risk. In addition to paying interest, debt financing frequently requires the borrower to follow certain financial performance guidelines. Covenants are the terms used to describe these norms.

Debt Financing vs. Equity Financing

The main difference between debt and equity financing is that equity financing offers additional working capital without requiring repayment. Debt financing must be repaid, but the company is not required to give up any equity to obtain funds.

Advantages and Disadvantages of Debt Financing

Debt financing has the advantage of allowing a company to leverage a small sum of money into a much bigger total, allowing for faster expansion than would otherwise be possible. Another benefit is that debt repayments are often tax-deductible. Furthermore, unlike equity funding, the corporation does not have to give up any ownership control. Debt financing is frequently less expensive than equity financing because equity financing poses a bigger risk to the investor than debt financing does to the lender.

The main disadvantage of debt financing is that interest must be paid to lenders, resulting in a payment that is greater than the amount borrowed. Debt payments must be made regardless of earnings, which can be especially problematic for smaller or newer enterprises that have yet to establish a reliable cash flow.