Question: When is it good for a company to issue debt? — Submitted by @JuniorBurgos
Answer: Finance can seem like a dizzyingly complex discipline full of dense concepts and esoteric jargon. But the field is founded upon — and mostly consists of — a few simple concepts. One example is that there are basically two ways to fund a business, assuming the owner doesn’t have enough money on hand: By selling ownership stakes in the company (otherwise known as equity), or by taking out debt.
So how does a company decide whether to fund itself with equity or debt? Big-name CFOs get paid tons of money to make that determination, and each industry and company is different, but each form of financing generally has its own pros and cons. When you take out debt — whether by borrowing money from a bank or issuing bonds to the public — there are three clear results: 1) You’ll owe the lender or lenders a fixed amount of money at predetermined dates; 2) your interest expenses are tax deductible; and 3) you’ll give up no control over the actual management of the firm.
On the other hand, if you choose to raise money instead by selling an ownership stake in the company, 1) you’ll only owe your investors money if you realize a profit, but the amount you end up paying them may be huge; 2) these dividend payments to investors are not tax deductible; and 3) your investors will likely have a say in how the company is managed.
Here you can see the appeal of debt over equity. If you expect your company to be successful, and you don’t like the idea of sharing control with other investors, debt is obviously the best way to go. The downside is that if your company isn’t successful, you still have to make those debt payments. And if you can’t, lenders will be first in line in a bankruptcy proceeding to collect what is owed them.
So are certain companies more apt to use debt or equity? So-called capital-intensive industries like auto manufacturers or airlines tend to carry more debt because they must purchase more property and equipment in order to be successful. The financial services industry tends to have very high debt loads as well. But a more reliable indicator of high debt loads is where a company is in the corporate life-cycle.
Start-up firms are usually reliant on the founders’ initial investments, and possibly a bit of bank debt. As a company expands, it will most likely seek out investments from venture capital firms, adding to the equity investment of its owners. Venture capital firms will seek to make a return on their investment by taking the company public — opening up the company to an even larger number of owners. Once a company begins to mature, however, potential investors will be less inclined to buy ownership stakes in the firm cheaply, because expected growth has slowed. At the same time, lenders will be eager to loan money cheaply because the company has steady profits and solid collateral. Mature companies, therefore, are more likely to rely on debt.
As you can see, many factors go into the decision of whether to fund a company with debt vs. equity. We tend to look askance at debt, because it enables individuals and companies to live beyond their means. But debt is not inherently bad — it’s simply one method of attracting investment. Debt is, however, fundamentally more risky than equity. A debt-financed company is going to bring in greater rewards for its founder than if the founder decides to share profits among many owners, but a high debt load also increases the chance that a company will fail.
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