Comparing the pros and cons of both, and understanding the relationship between WACC and leverage
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Debt vs Equity Financing – which is best for your business and why? The simple answer is that it depends. The equity versus debt decision relies on a large number of factors such as the current economic climate, the business’ existing capital structure, and the business’ life cycle stage, to name a few. In this article, we will explore the pros and cons of each, and explain which is best, depending on the context.
Definition of terms
From a business perspective:
Debt: Refers to issuing bonds to finance the business.
Equity: Refers to issuing stock to finance the business.
We recommend reading through the articles first if you are not familiar with how stocks and bonds work.
To answer this question, we must first understand the relationship between the Weighted Average Cost of Capital (WACC) and leverage. Generally speaking, the best capital structure for a business is the capital structure that minimizes the business’ WACC. As the chart below suggests, the relationships between the two variables resemble a parabola.
At point A, we see a capital structure that has a low amount of debt and a high amount of equity, resulting in a high WACC. At point B, we see the opposite: a capital structure with a high amount of debt and a low amount of equity – which also results in high WACC. In order to minimize WACC, the capital structure must consist of a balanced combination of debt and equity.
Why is too much equity expensive?
The Cost of Equity is generally higher than the Cost of Debt since equity investors take on more risk when purchasing a company’s stock as opposed to a company’s bond. Therefore, an equity investor will demand higher returns (an Equity Risk Premium) than the equivalent bond investor to compensate him/her for the additional risk that he/she is taking on when purchasing stock. Investing in stocks is riskier than investing in bonds because of a number of factors, for example:
The stock market has a higher volatility of returns than the bond market
Stockholders have a lower claim on company assets in case of company default
Capital gains are not a guarantee
Dividends are discretionary (i.e., a company has no legal obligation to issue dividends)
Thus, financing purely with equity will lead to a high WACC.
Why is too much debt expensive?
While the Cost of Debt is usually lower than the cost of equity (for the reasons mentioned above), taking on too much debt will cause the cost of debt to rise above the cost of equity. This is because the biggest factor influencing the cost of debt is the loan interest rate (in the case of issuing bonds, the bond coupon rate).
As a business takes on more and more debt, its probability of defaulting on its debt increases. This is because more debt equals higher interest payments. If a business experiences a slow sales period and cannot generate sufficient cash to pay its bondholders, it may go into default. Therefore, debt investors will demand a higher return from companies with a lot of debt, in order to compensate them for the additional risk they are taking on. This higher required return manifests itself in the form of a higher interest rate.
Thus, financing purely with debt will lead to a higher cost of debt, and, in turn, a higher WACC.
It is also worth noting that as the probability of default increases, stockholders’ returns are also at risk, as bad press about potential defaulting may place downward pressure on the company’s stock price. Thus, taking on too much debt will also increase the cost of equity as the equity risk premium will increase to compensate stockholders for the added risk.
The optimal capital structure is one that minimizes the Weighted Average Cost of Capital (WACC) by taking on a mix of debt and equity. Point C on the chart below indicates the optimal capital structure on the WACC versus leverage curve:
If the business is at point A on the curve, issuing debt would bring down its WACC. If the business is at point B on the curve, issuing equity would bring down its WACC. For more details on calculating WACC, click here.
Other factors to consider
Below are other important factors that need to be taken into consideration when making a financing decision:
Flotation costs: If investment banks are charging a lot to issue (or “float”) new stock, issuing debt will be cheaper and vice versa.
Interest rates: High interest rates will require the business to offer high coupon bonds in order to be an attractive investment. This will be more costly, thus issuing equity will be cheaper and vice versa.
Tax rates: High tax rates will deduct from bondholders’ returns as they will need to give more of their coupon away. Thus, they will demand higher returns to compensate. In this case, issuing equity will be cheaper and vice versa.
Earnings volatility: If the business is seasonal, or sees volatile revenues each month, it will be difficult to guarantee enough cash will be available for coupon payments. Therefore, issuing equity will be a better decision and vice versa.
Business growth: If the company is fairly young and is making significant investments in R&D in order to support growth, it may be wiser to reduce monthly claims on cash flows by issuing equity and vice versa.
The table below easily summarizes the debt vs equity decision:
*Assuming all other factors remain the same
Thank you for reading this guide on debt vs equity and the pros and cons of each type of financing. To keep learning and advancing your career as an analyst, the following CFI resources will also be helpful:
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