Debt and equity financing are the two major modes of financing a corporation. Fundamental to this discussion, it is imperative to draw a distinction between the two modes of financing as well as to specify both the advantages and disadvantages associated with each method. Equity financing means using share capital to finance operations of an organization. Share capital refers to the funds raised from shareholders either through the initial offer or through issuing additional shares. This implies that an organization using this option exchanges ownership for funds. On the other hand, debt financing is the act of financing the operations of a company from borrowed money without giving up ownership. As a matter of fact, it is impossible to state which mode of financing is better as it depends on situations (Kuo, 1989).
Advantages of Debt Financing
Debt financing is often preferred to equity financing since it is cheaper for a corporation to finance its operations through borrowing. Unlike equity, debt financing does not dilute ownership interest since lenders lack a claim to ownership in an organization. Secondly, lenders do not have right for the firm’s future profits. Thus, if a firm is successful, the owners reap larger profits than they would in the case of equity financing, where some profits are distributed to shareholders in the form of dividends. This favors expansion of operations. Furthermore, raising debt capital can be much easier compared to equity capital since the firm is required to comply with few laws and regulations.
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Disadvantages of Debt Financing
Debt financing can be a riskier mode of financing in the sense that, whether a company makes profits or losses, interest on the debt, unlike dividends, must be repaid. Additionally, interest on debt has the effect of raising a firm’s break-even point. This, in turn, raises the risk of insolvency. Besides, debt financing limits growth of a firm due to the high cost of servicing debt. From another perspective, lenders attach more restrictions to their funds than investors; they usually need collateral before lending. This implies that a firm’s ability to borrow is restricted by the amount of collateral it can actually raise (Chapman & Rodney, 2004).
Advantages of Equity Financing
Equity financing is preferred to debt financing in the sense that there is no obligation to pay out dividends to shareholders. Especially this is a case in times when the firm incurs losses. Moreover, equity financing, opposite to debt financing, requires no collateral (security). Consequently, there is the little limitation on a number of funds that a firm can actually raise. Besides, since shareholders would want to reap huge profits, they may provide technical assistance to the firm (Ryan, & O’Brien, 1990).
Disadvantages of Equity Financing
Equity financing has the effect of diluting ownership and control of the owner since funds are exchanged for ownership. Furthermore, since the firm is not obliged to pay dividends, especially in the event of losses, directors may be reluctant in improving the firm’s performance. In this regard, it is necessary to note that empirical studies have suggested that firms using debt financing usually record better performance than those using equity financing.