How do companies raise funds : Debt vs Equity
Updated: Jul 4, 2020
If you follow the news closely, we often keep hearing that companies raise money using bonds, debentures, commercial papers etc. or by selling shares. What exactly are these?
Let's say there is a company XYZ, which is planning to start a new factory. Now they need funds for building this factory
There are usually 2 ways XYZ can explore to raise money : One using debt and one using equity
What is debt capital?
When a company decides to raise funds by borrowing from a bank or by using debt instruments such as bonds, commercial papers, notes etc.
What is equity capital?
When a company decides to raise funds by selling shares, thereby diluting the stake of the existing investors in the company
How are debt and equity capital different?
If XYZ raises capital using debt, then it is required to pay a fixed interest rate every month along with the original amount borrowed at the end of the tenure
But if XYZ raises capital using equity, they don't have to pay back the money, however, since their ownership is diluted because they sold new shares, your share of profit now will be less, since its distributed among larger shares
To understand this better, let's say XYZ has 100 shares and earned 100 rupees profit. Each share will be entitled to get 1 rupee. Now let's say they have issued 100 new shares to raise money for this new factory. Now the total becomes 200. And if they earn same 100 profit, this 100 will now be distributed among 200 instead of 100, thus reducing the earnings per share ( EPS ) to 0.5 from 1
Which is better, raising money through debt or equity?
This usually depends on the company and the nature of the industry:
If a company believes that they already have high debt and don't want to accumulate more debt, in such cases they go for equity
If it’s a new or growing company, they might not be having much profits to pay the interest each month, so they resort to equity capital
If it's an established company with steady profits each year, then they usually go for debt capital than equity
So, it really depends on the company, the industry it operates in and the existing debt
Which is more costly, raising capital by debt or equity?
Cost of equity is more than cost of debt, since you are losing your ownership in equity whereas you are retaining that in debt
In the next post, we'll look at the various debt instruments available for the companies to raise money and how do they differ from each other