Debt Vs. Equity Financing
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1. What is debt financing? Give at least two examples.
2. What is equity financing? Give at least two examples.
3. Which alternative capital structure is more advantageous? Why?
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Solution Summary
This discusses the Debt Vs. Equity Financing
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Debt Financing
This is raising money from the lenders. They pay interest to the lenders. The various option of debt is:
Bonds
It is a fixed income (debt) instrument issued for a period of more than one year with the purpose of raising capital. The central or state government, corporations and similar institutions sell bonds. A bond is generally a promise to repay the principal along with fixed rate of interest on a specified date, called as the maturity date.
Issue Convertible Debenture
It is issuing of convertible debentures to which will be convertible into equity after few years. It involves selling of ordinary shares in future at a higher price.
Convertible warrants
A warrant entitles the purchaser to buy a fixed number of ordinary shares at a particular price during a specified time period. It is similar to an American call option.
Zero-Interest Debentures
ZID or zero coupon bonds or deep discount bonds do not carry an explicit rate of interest. The difference between the face value of the bonds and its purchase price is the return to the investors.
Mezzanine Capital. The capital often includes two or more layers of debt: senior debt, which is secured by assets, and subordinated debt, which is unsecured but which often includes an equity kicker. This second level of debt is called "mezzanine capital."
Equity kicker means convertible debt that is debt converted into equity.
Hence the above sources can be used to fund the high-risk high return project.
Advantages
1) Less Costly
This is a cheaper option to a certain extent as compared to the equities as investor bear less risk.
2) No ownership Dilution
The ownership is not shared with the debt holders and they also don't have any voting rights.
3) Fixed payment of interest
The cash outflows can be easily predicted
4) Reduced real obligation
The real obligation is less as this provides the tax shield
5) Improvement in ROE
The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owners' equity. The rate of return on the owners' equity is levered above or below the rate of return on total assets. (I.M. Pandey)
Thus the use of the fixed-charges ...
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