In our last article, we discussed stock dilution which can be the result of a company raising more equity. However, companies can also raise money through debt financing. In this article we discuss the pros and cons of debt financing.
Pros of debt financing
1.Ownership. When companies choose debt to finance new projects, they are keeping the company ownership as is. However, when they raise equity instead, investors who buy an equity position of a company also obtain a part ownership too. Hence debt raising methods maintains the company ownership as it currently is so there is no change in voting rights.
2.Profits. With debt financing, companies are only required to pay the repayments on the loan. They are not obligated to distribute company profits to their lenders. In an equity raising, companies distribute their excess profits in the form of dividends to their shareholders.
3.When the debt is paid off there is no longer any obligation to the lender. With equity raisings, the shareholder will always have a part ownership.
Cons of Debt Financing
1.Debt Obligation. Companies who take out loans are obligated to pay the loan back with regular instalments throughout the life of the loan. In equity financing, the company doesn’t need to pay back the shareholder for share purchases.
2. Bankruptcy. Debt needs to be repaid back in the event of a bankruptcy. Creditors are ranked higher than shareholders in the event of insolvency so the companies are obligated to pay back the loan to creditors even if the business collapses. Shareholders do not receive anything back if the company they have invested in has gone bankrupt.
3. Sensitive to interest rate rises. When a company has a lot of debt then interest rate hikes will have a huge impact on their loan obligations. This in effect can increase expenses and decrease net profits.
Lauren Hua is a private client adviser at Fairmont Equities.
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