To raise additional funds for doing business, the company can use various external sources, including debt and income from the sale of shares. Debt financing assumes borrowing money from investors by outputting corporate bonds (Brealey et al., 2018). Equity financing involves the sale of ownership rights in a company to investors by issuing shares. Depending on several aspects, including the current economic situation, the existing capital structure of the business, and the stage of the life cycle, a company may prefer one or another type of financing.
Equity financing is considered less risky compared to debt financing. Moreover, a rise in the value of the shares could enhance the company’s credit rating and simplify borrowing money in the future. It can be challenging for a new company to pay off its debt obligations, especially during economic downturns and rising interest rates. Nevertheless, equity financing still carries certain risks since shareholders can influence the significant operating decisions of the company. Thus, this type of financing is preferable for new companies that have insufficiently strong market positions, as well as start-up businesses.
In turn, in the long term, borrowed capital is cheaper than equity. If a company plans to expand, debt is almost always the more affordable option. Thus, debt financing can be chosen by a fast-growing company, which would be a less expensive form of funding for it. It is advisable when the growth rate in the value of the business’s equity capital is higher than the cost of borrowing debt. However, there must be sufficient operating cash flow generated by the entity to service interest and principal obligations, or there could be profound business implications. Another benefit is that debt financing provides some tax incentives that equity financing does not offer. It applies when the company is not at a loss. Thus, the type of financing choice depends on such factors as the actual economic situation, the business’s capital structure, and the stage of the company’s life cycle.