Equity and debt are the two sources of financing accessible in capital markets. The term capital structure refers to the overall composition of a company's funding. Alterations to capital structure can impact the cost of capital, the net income, the leverage ratios and the liabilities of publicly traded firms.
The weighted average cost of capital (WACC) measures the total cost of capital to a firm. Assuming that the cost of debt is not equal to the cost of equity capital, the WACC is altered by a change in capital structure. The cost of equity is typically higher than the cost of debt, so increasing equity financing usually increases WACC.
Equity financing – raising money by selling new shares of stock – has no impact on a firm's profitability, but it can dilute existing shareholders' holdings, because the company's net income is divided among a larger number of shares. When a company raises funds through equity financing, there is a positive item in the cash flows from financing activities section and an increase of common stock at par value on the balance sheet.
If a firm raises funds through debt financing, there is a positive item in the financing section of the cash flow statement as well as an increase in liabilities on the balance sheet. Debt financing includes principal, which must be repaid to lenders or bondholders, and interest. While debt does not dilute ownership, interest payments on debt reduce net income and cash flow. This reduction in net income also represents a tax benefit through the lower taxable income. Increasing debt causes leverage ratios such as debt-to-equity and debt-to-total capital to rise. Debt financing often comes with covenants, meaning that a firm must meet certain interest coverage and debt-level requirements. In the event of a company's liquidation, debt holders are senior to equity holders.