DEBT OR EQUITY????

There are 2 ways for businesses to raise fund, which are debt financing and equity financing. Both two of them brings different benefits to organizations as well as different level of risks such as interest rate..

Debt financing is making a loan from Banks or issuing bonds both long term and short term and need to repay the loan and also the interest. Meanwhile, Equity financing includes retained earning and share. Retained earning means that instead of paying out as evidence for the shareholders, the company uses their earning as capital to reinvest. Besides, issuing share is capital comes from selling common stock or preferred stock to investors.

Using debt-financing sources to raise fund, companies may know in advance the sum of loan and also plus interest which must be paid (they were set at the beginning). Therefore, they may have a right strategy to be able to pay back the loan also make profit. The other advantage of debt financing is managers have the right to make decision. There is no dilution. When the lenders raise a fund for the business, they also give him the freedom to make decision during the period of running the business. The lender has no right in the future or direction of the business as long as the loan payments are made.

Tax deduction is the attractive and important advantages of debt financing because the principal and interest payment is considered as the business’s expense, we can consider paying loan and interest s a part of cost. As formulation:

Revenue – cost = profit.

The revenue does not change, costs increase so it makes the profit decreases. It means that the tax which the company must pay to the government decrease, too. Therefore, the sum of money can be deducted from the business income taxes.

However, in some case, with the limited capital from Bank, companies are unable to manage their activities. Another situation is the company is unable to pay back, or even become bankruptcy. It also suffer shareholders’ right because organization’s assets must be used to pay tax for government and loan for all debtors before paying to shareholders.

It is really a burden for the business when the business need to payback a part of the principal and interest monthly. Moreover, the business may be penalty when it pays back late or miss payment. Another weak point is the interest rate was fixed at the beginning. Therefore, organizations still have to pay the high rate interest  if the economic is in recession.

Another source of fund is equity. By using this source, companies do not need to care much about the burden of debt. In addition, if the company issue ordinary share, it does not need to pay the dividend on time to the investors if it still need capital (retained earning). Besides, equity financing is a good source for business. Not only not to worry much about the dateline to payback money, it also does not need to think about the obligations and penalties of the banks or other organizations when it cannot pay back money on time. More and more investors provide capital for the company, it synonym to the risk of the company will be shared to them, the members of the company do not need to take all the responsibilities.

However, raising money by equity financing also has some drawbacks, such as the dilution of the ownership interest and loosing of control. It means that the owner has to give a part of rights and profits to the investors because the investors have the right to vote and make decisions. However, if preference shares are issued, the investors do not have this right.

Another risk of equity financing is the change in investment of the investors. They may chance their decision to invest to another company. One of the factors that makes the investor change their decision is the failure to pay ordinary dividend from the company. The last weak point of equity financing is the complicated regulation to issue shares in the market share. It is not only to complex to issue the share, the company also need to use a large sum of money for flotation cost and pay back the dividend for the shareholders.            

Besides the two costs above, the company also has to pay tax for government, which was fixed, and not change. The company, which issues shares, has no benefits. If the before- tax profit is large, after subtracting the tax cost, the after- tax profit that is used to pay the dividend for the shareholders is large, too. In contrast, if the before- tax profit is small, it leads to the fact that the after- tax profit that is used to pay the dividend for the shareholders is small, too. So a corporate tax adjustment does not concern with the cost of shares.