There are two types of capital that a company can use to fund operations—debt and equity. Prudent corporate finance practice involves determining the mix of debt and equity that is most cost-effective.
The most common types of debt capital are bank loans, personal loans, bonds, and credit card debt. When looking to expand, a company can raise additional capital by applying for a new loan or opening a line of credit. This type of funding is referred to as debt capital because it involves borrowing money under a contractual agreement to repay the funds at a later date.
With the possible exception of personal loans from very generous friends or family members, debt capital carries with it the additional burden of interest. This expense, incurred just for the privilege of accessing funds, is referred to as the cost of debt capital.
- Businesses can use either debt or equity capital to raise money—where the cost of debt is usually lower than the cost of equity given debt has recourse.
- Debt holders usually charge businesses interest, while equity holders rely on stock appreciation or dividends for a return.
- Preferred equity has a senior claim on a company’s assets compared to common equity, making the cost of capital lower for preferred equity.
Assume a company takes out a $100,000 business loan from a bank that carries a 6% annual interest rate. If the loan is repaid one year later, the total amount repaid is $100,000 * 1.06, or $106,000. Of course, most loans are not repaid so quickly, so the actual amount of compounded interest on such a large loan can add up quickly.
The accumulation of interest is one of the drawbacks of debt capital. In addition, payments must be made to lenders regardless of business performance. In a low season or bad economy, a highly leveraged company may have debt payments that exceed its revenue.
Lenders are guaranteed payment on outstanding debts even in the absence of adequate revenue.
Equity capital is generated by the sale of shares of stock. If taking on more debt is not financially viable, a company can raise capital by selling additional shares. These can be either common shares or preferred shares.
Preferred shares are unique in that payment of a specified dividend is guaranteed before any such payments are made on common shares. In exchange, preferred shareholders have limited ownership rights.
The primary benefit of equity capital is that, unlike debt capital, the company is not required to repay shareholder investment. Instead, the cost of equity capital refers to the amount of return on investment shareholders expect based on the performance of the larger market. These returns come from the payment of dividends and stock valuation. The disadvantage to equity capital is that each shareholder owns a small piece of the company, so business owners are beholden to their shareholders and must ensure the business remains profitable to maintain an elevated stock valuation while continuing to pay any expected dividends.
Debtholders are generally known as lenders, while equity holders are known as investors.
Because preferred shareholders have a higher claim on company assets, the risk to preferred shareholders is lower than to common shareholders, who occupy the bottom of the payment food chain. Therefore, the cost of capital for the sale of preferred shares is lower than for the sale of common shares. In comparison, both types of equity capital are typically more costly than debt capital, since lenders are always guaranteed payment by law.