Businesses often need external money to maintain their operations and invest in future growth. There are two types of capital that can be raised: debt and equity.
Debt financing is capital acquired through the borrowing of funds to be repaid at a later date. Common types of debt are loans and credit. The benefit 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.
In addition, payments on debt are generally tax-deductible. The downside of debt financing is that lenders require the payment of interest, meaning the total amount repaid exceeds the initial sum. Also, payments on debt must be made regardless of business revenue. For smaller or newer businesses, this can be especially dangerous.
Equity financing refers to funds generated by the sale of stock. The main benefit of equity financing is that funds need not be repaid. However, equity financing is not the "no-strings-attached" solution it may seem.
Shareholders purchase stock with the understanding that they then own a small stake in the business. The business is then beholden to shareholders and must generate consistent profits in order to maintain a healthy stock valuation and pay dividends. Since equity financing is a greater risk to the investor than debt financing is to the lender, the cost of equity is often higher than the cost of debt.
How to Choose Between Debt and Equity
The amount of money that is required to obtain capital from different sources, called cost of capital, is crucial in determining a company's optimal capital structure. Cost of capital is expressed either as a percentage or as a dollar amount, depending on the context.
The cost of debt capital is represented by the interest rate required by the lender. A $100,000 loan with an interest rate of 6% has a cost of capital of 6%, and a total cost of capital of $6,000. However, because payments on debt are tax-deductible, many cost of debt calculations take into account the corporate tax rate.
Assuming the tax rate is 30%, the above loan would have an after-tax cost of capital of 4.2%.
Cost of Equity Calculations
The cost of equity financing requires a rather straightforward calculation involving the capital asset pricing model or CAPM:
CAPM=(Company’s Beta × Risk Premium)Risk Free Rate
By taking into account the returns generated by the larger market, as well as the individual stock's relative performance (represented by beta), the cost of equity calculation reflects the percentage of each invested dollar that shareholders expect in returns.
Finding the mix of debt and equity financing that yields the best funding at the lowest cost is a basic tenet of any prudent business strategy. To compare different capital structures, corporate accountants use a formula called the weighted average cost of capital, or WACC.
The WACC multiplies the percentage costs of debt—after accounting for the corporate tax rate—and equity under each proposed financing plan by a weight equal to the proportion of total capital represented by each capital type.
This allows businesses to determine which levels of debt and equity financing are most cost-effective.