Every business needs capital to operate successfully. Capital is the money a business—whether it's a small business or a large corporation—needs and uses to run its day-to-day operations. Capital may be used to make investments, conduct marketing and research, and pay off debt.
There are two main sources of capital companies rely on—debt and equity. Both provide the necessary funding needed to keep a business afloat, but there are major differences between the two. And while both types of financing have their benefits, each also comes with a cost.
Below, we outline debt and equity capital, and how they differ.
Key Takeaways
Debt and equity capital both provide businesses money they need to maintain their day-to-day operations.
Companies borrow debt capital in the form of short- and long-term loans and repay them with interest.
Equity capital, which does not require repayment, is raised by issuing common and preferred stock, and through retained earnings.
Most business owners prefer debt capital because it doesn't dilute ownership.
Debt capital refers to borrowed funds that must be repaid at a later date. This is any form of growth capital a company raises by taking out loans. These loans may be long-term or short-term such as overdraft protection.
Debt capital does not dilute the company owner's interest in the firm. But it can be cumbersome to pay back interest until its loans are paid off—especially when interest rates are rising.
Companies are legally required to pay out interest on debt capital in full before they issue any dividends to shareholders. This makes debt capital higher on a company's list of priorities over annual returns.
While debt allows a company to leverage a small amount of money into a much greater sum, lenders typically require interest payments in return. This interest rate is the cost of debt capital. Debt capital can also be difficult to obtain or may require collateral, especially for businesses that are in trouble.
If a company takes out a $100,000 loan with a 7% interest rate, the cost of capital for the loan is 7%. Because payments on debts are often tax-deductible, businesses account for the corporate tax rate when calculating the real cost of debt capital by multiplying the interest rate by the inverse of the corporate tax rate. Assuming the corporate tax rate is 30%, the loan in the above example then has a cost of capital of 0.07 X (1 - 0.3) or 4.9%.
Equity Capital
Because equity capital typically comes from funds invested by shareholders, the cost of equity capital is slightly more complex. Equity funds don't require a business to take out debt which means it doesn't need to be repaid. But there is some degree of return on investment shareholders can reasonably expect based on market performance in general and the volatility of the stock in question.
Companies must be able to produce returns—healthy stock valuations and dividends—that meet or exceed this level to retain shareholder investment. The capital asset pricing model (CAPM) utilizes the risk-free rate, the risk premium of the wider market, and the beta value of the company's stock to determine the expected rate of return or cost of equity.
Equity capital reflects ownership while debt capital reflects an obligation.
Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company's profit margins.
Equity capital may come in the following forms:
Common Stock: Companies sell common stock to shareholders to raise cash. Common shareholders can vote on certain company matters.
Preferred Stock: This type of stock gives shareholders no voting rights, but does grant ownership in the company. These shareholders do get paid before common stockholders in case the business is liquidated.
Retained Earnings: These are profits the company has retained over the course of the business' history that has not been paid back to shareholders as dividends.
Equity capital is reported on the stockholder's equity section of a company's balance sheet. In the case of a sole proprietorship, it shows up on the owner's equity section.
Equity capital reflects ownership while debt capital
debt capital
Debt capital is the capital that a business raises by taking out a loan. It is a loan made to a company, typically as growth capital, and is normally repaid at some future date.
reflects an obligation. Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company's profit margins.
The cost of debt refers to the amount of interest a company pays on its borrowings, essentially the debt held by debt holders of a company. The cost of equity, on the other hand, is the rate of return expected by equity investors or shareholders. It involves the equities and securities held by investors.
Equity capital is the funds raised by the company in exchange for ownership rights for the investors.Debt Capital is a liability for the company that they have to pay back within a fixed tenure.
Debt financing raises funds by borrowing. Equity financing raises funds from within the firm through investment of retained earnings, sale of stock to investors, or sale of part ownership to venture capitalists.
What is the difference between debt financing and equity financing? Equity financing involves selling shares of ownership in the company while debt financing does not.
Capital refers to the total amount of money invested in a company by its owners, shareholders or investors. On the other hand, equity pertains to the ownership interest of an individual or group in a business entity. It represents the value of assets minus liabilities that is attributable to the owners or shareholders.
Debt finance is money provided by an external lender, such as a bank.Equity finance provides funding in exchange for part ownership of your business, such as selling shares to investors. Both have pros and cons, so it's important to choose the right one for your business.
The cost of debt is the total interest expense owed on a debt. Put simply, the cost of debt is the effective interest rate or the total amount of interest that a company or individual owes on any liabilities, such as bonds and loans. This expense can refer to either the before-tax or after-tax cost of debt.
Debt financing involves the borrowing of money, whereas equity financing involves selling a portion of equity in the company. The main advantage of equity financing is that there is no obligation to repay the money acquired through it.
Capital structure refers to a company's mix of capital—its debt and equity. Equity is a company's common and preferred stock plus retained earnings. Debt typically includes short-term borrowing, long-term debt, and a portion of the principal amount of operating leases and redeemable preferred stock.
Debt is less risky than equity, as the payment of interest is often a fixed amount and compulsory in nature, and it is paid in priority to the payment of dividends, which are in fact discretionary in nature.
Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company's profit margins.
Debt finance requires no equity dilution, but the business must “pay” for this benefit via interest on top of the initial sum. Equity finance doesn't require the payment of any interest, but it does mean sacrificing a stake in the business and ultimately a share of future profits.
Both are valid for financing the company's activity but have significant differences and implications. The main difference between debt and equity is that debt is the amount a borrower needs to repay with interest over a set period, while equity is the capital that a company owns and has no repayment obligation.
WACC is the total cost of all capital.CAPM is used to determine the estimated cost of shareholder equity. The cost of equity calculated from the CAPM can be added to the cost of debt to calculate the WACC.
The cost of capital is the total cost of debt and equity that a company incurs to run its operations. This method doesn't consider the relative proportion of each source of financing. WACC, on the other hand, goes a step further by considering the proportion of each financing source used by the company.
ROE measures a company's profitability by comparing its net income to its shareholder equity. WACC, on the other hand, is used to determine the minimum rate of return a company must earn in order to satisfy its investors and creditors.
In general, the cost method is used when the investment doesn't result in a significant amount of control or influence in the company that's being invested in, while the equity method is used in larger, more-influential investments.
Introduction: My name is Tyson Zemlak, I am a excited, light, sparkling, super, open, fair, magnificent person who loves writing and wants to share my knowledge and understanding with you.
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