Discuss pros and cons of using debt financing versus equity

Discuss pros and cons of using debt financing versus equity financing. Support your answer with real world examples and/or theoretical framework from the assigned readings. Also, discuss whether or not, all else equal, firms with relatively volatile sales are able to carry relatively high debt ratios. Provide an example of a company with relatively volatile sales.

Solution

When financing a company with debt, the interest expense is the cost that company pays on its debt. With equity, the cost refers to the claim on earnings provided to shareholders in proportion to their stake in the company.

For example: if you run a small business and need $60,000, you can either take out a $60,000 bank loan at a 10% interest rate which is debt financing or you can sell a 30% stake in your business to your friend for $60,000 which is equity financing

Suppose your business earns a $30,000 profit during the next year. If you took the bank loan, your interest expense would be $6,000, leaving you with $24,000 in profit. Also, interest expense is tax deductible, you would earn because of this tax shield.

Whereas, if you used equity financing, you would have zero debt, but would keep only 70% of your profit (the other 30% being owned by friend). Therefor, your personal profit would only be $21,000, or (70% x $30,000).

In example above we can see debt financing is coming out to be cheaper than equity financing but if instead of selling stake of 30% you only sell 10% stake to your friend then equity will be more cheap then debt financing.

Therefore, to get the most profits one should use the combination of bothe debt and equity depending on the cost of capital.