A:

In this case, the "cost" being referred to is the measurable cost of obtaining capital. With debt, this is the interest expense a company pays on its debt. With equity, the cost of capital refers to the claim on earnings which must be afforded to shareholders for their ownership stake in the business.

For example, if you run a small business and need $40,000 of financing, you can either take out a $40,000 bank loan at a 10% interest rate or you can sell a 25% stake in your business to your neighbor for $40,000.

Suppose your business earns $20,000 profits during the next year. If you took the bank loan, your interest expense (cost of debt financing) would be $4,000, leaving you with $16,000 in profit.

Conversely, had you used equity financing, you would have zero debt (and thus no interest expense), but would keep only 75% of your profit (the other 25% being owned by your neighbor). Thus, your personal profit would only be $15,000 (75% x $20,000).

From this example, you can see how it is less expensive for you, as the original shareholder of your company, to issue debt as opposed to equity. Taxes make the situation even better if you had debt, since interest expense is deducted from earnings before income taxes are levied, thus acting as a tax shield (although we have ignored taxes in this example for the sake of simplicity).

Of course, the advantage of the fixed-interest nature of debt can also be a disadvantage, as it presents a fixed expense, thus increasing a company's risk. Going back to our example, suppose your company only earned $5,000 during the next year. With debt financing, you would still have the same $4,000 of interest to pay, so you would be left with only $1,000 of profit ($5,000 - $4,000). With equity, you again have no interest expense, but only keep 75% of your profits, thus leaving you with $3,750 of profits (75% x $5,000).

So, as you can see, provided a company is expected to perform well, debt financing can usually be obtained at a lower effective cost. However, if a company fails to generate enough cash, the fixed-cost nature of debt can prove too burdensome. This basic idea represents the risk associated with debt financing.

Companies are never 100% certain what their earnings will amount to in the future (although they can make reasonable estimates), and the more uncertain their future earnings, the more risk presented. Thus, companies in very stable industries with consistent cash flows generally make heavier use of debt than companies in risky industries or companies who are very small and just beginning operations. New businesses with high uncertainty may have a difficult time obtaining debt financing, and thus finance their operations largely through equity.

(For more on the costs of capital, see Investors Need A Good WACC.)

RELATED FAQS
  1. When should a business avoid debt financing?

    Read about the optimal use of debt in a business capital structure and how to know when a business should avoid further debt ... Read Answer >>
  2. How does a company choose between debt and equity in its capital structure?

    Learn about the benefits and drawbacks of debt and equity financing and how companies compare different capital structures ... Read Answer >>
  3. What are the benefits and shortfalls of the Herfindahl-Hirschman Index?

    Learn about the differences between equity and debt financing and how they impact financials. Find out how businesses determine ... Read Answer >>
  4. How does a company's capitalization structure affect its profitability?

    Learn about capitalization structure and how the combination of debt and equity a company uses to fund operations can affect ... Read Answer >>
Related Articles
  1. Small Business

    Small Business Financing: Debt Or Equity?

    There are two sources of financing for small businesses: debt and equity financing. This article explains both.
  2. Small Business

    The Basics Of Financing A Business

    From debt financing to equity financing, there are numerous ways to fund a business startup. But which is the best?
  3. Personal Finance

    How to Invest When You're Deep in Debt

    Debt is one of the biggest obstacles that prevents people from investing - but it shouldn't be.
  4. Investing

    To Invest Or To Reduce Debt, That's The Question

    Find out how you can make use of that excess cash and improve your financial situation.
  5. Personal Finance

    Professors: Slash Your Debt or Build a Nest Egg?

    If you're a professor with a sizable amount of debt, paying it off and investing do not have to be mutually exclusive.
  6. Personal Finance

    The 7 Best Ways to Get Out of Debt

    Obtain information on how to put together and execute a plan to get out of debt, including the various steps and methods people use to become debt-free.
  7. Investing

    Will Corporate Debt Drag Your Stock Down?

    Borrowed funds can mean a leg up for companies or the boot for investors. Find out how to tell the difference.
  8. Small Business

    What is Equity Financing?

    Companies that are short on cash may need financing to pay for short-term needs or long-term capital expenditures.
  9. Retirement

    Debt, Savings, Retirement: Where Should Your Money Go?

    Come up with a money management plan that will help you allocate your funds effectively.
  10. Personal Finance

    7 Tips For The Do-It-Yourself Debt Manager

    Hired gun not in your budget? Learn to be your own credit counselor.
RELATED TERMS
  1. Cost Of Capital

    The required return necessary to make a capital budgeting project, ...
  2. Cost Of Debt

    The effective rate that a company pays on its current debt. This ...
  3. Long-Term Debt To Capitalization Ratio

    A ratio showing the financial leverage of a firm, calculated ...
  4. Debt Service

    The cash that is required for a particular time period to cover ...
  5. Long-Term Debt

    Long-term debt consists of loans and financial obligations lasting ...
  6. Secured Debt

    Debt backed or secured by collateral to reduce the risk associated ...
Hot Definitions
  1. Price Elasticity Of Demand

    A measure of the relationship between a change in the quantity demanded of a particular good and a change in its price. Price ...
  2. Market Capitalization

    The total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying ...
  3. Frexit

    Frexit – short for "French exit" – is a French spinoff of the term Brexit, which emerged when the United Kingdom voted to ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Down Round

    A round of financing where investors purchase stock from a company at a lower valuation than the valuation placed upon the ...
  6. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
Trading Center