A firm’s capital structure consists of proportions of debt and equity. It could finance itself through equity only or a combination of both debt and equity. The decision to finance from equity or debt has major implications on its long term sustainability and may affect the value of the firm.
Debt Financing
Advantages:
· Tax advantage as interest is deductible for income tax purposes, thus cheaper to obtain compared to equity.
· Motivates manager to borrow more
· It does not dilute the ownership of the business
Disadvantages:
· The risk and cost of financial distress increases with the increase in debt i.e. capital and interest payment is made regardless of business performance. (increase in financial risk)
· In the event of bankruptcy, debt holders are secured and they will be paid first.
Equity Financing
Advantages:
· Investors may offer valuable business assistance i.e. skills, contacts and experience, especially in early days of a new firm.
· No need to keep up with cost of servicing bank loans or debt finance, allowing capital to be used solely for business activities. Investors do not expect returns immediately.
· Investors are often prepared to provide follow-up funding as the business grows.
· If the business fails, investors will not get their money back. Thus investors have a vested interest in the business success i.e. its growth, profitability and increase in value.
Disadvantages:
· Raising equity finance is demanding, costly and time consuming, and may take management focus away from the core business.
· It dilutes business ownership, thus may lead to loss of control of managing the business.
· Investors expect a share of profits, compared to deft finance, lenders only expect their loans repaid.
· Prepared to invest time to provide regular information for investors to monitor.
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