Companies use both debt and equity to finance their business activities, and the mix of debt and equity constitutes a business’s capital structure. Companies choose between debt and equity depending on their current and expected future profitability. In general, the use of debt can put certain financial constraints on a business, but in exchange it allows greater returns for the company's current equity holders. The cost of debt often is cheaper than the cost of equity, but the use of debt can have a potentially negative effect on the overall future financing cost of a company.
A major advantage to the use of debt is that debt helps generate and retain greater investment returns for a company’s equity holders. A company may choose to use debt if it can afford making scheduled, fixed debt repayments, while expecting potential high growth in the future. Unlike equity financing that gives away a share of profits to new investors, the use of debt allows most of the profits to be retained within the company because debt holders are entitled to only the amount of interest agreed on. Moreover, the increased amount of capital from debt can generate additional returns for current equity holders.
Cost and Tax
Borrowing costs from the use of debt usually are less expensive than those on equity financing, because debt holders enjoy greater guarantees about the safety of their investments than equity holders, thus bearing fewer investment risks. The lower cost of debt financing helps bring down the required rate of return on the capital project being financed, improving its profit margins. The use of debt also has a tax advantage compared to equity financing. Interest spent on debt borrowing is tax deductible, allowing for tax savings depending on a company’s tax rate, while dividends paid out to equity holders must come from a company’s after-tax income.
The most common disadvantage to the use of debt is the financial distress that debt can exert on a company. Companies that have a high debt-to-equity ratio in their capital structure may see an increased risk in potential bankruptcy. Without enough equity as a cushion to absorb potential asset losses, declines in asset value can further spread into debt, prompting debt holders to seek court protection. The burden of making ongoing debt payments can also cause financial distress on a company. Failure to make scheduled payments may force a company into a default status.
There often is a trade-off between obtaining inexpensive debt financing in the present and potentially sustaining higher financing costs in the future. Because the use of debt adds financial distress and increases the risk of potential bankruptcy for a company, future investors, both debt and equity investors, may require higher rates of return on their investments, increasing a company’s financing costs. While companies should take advantage of debt financing, they should also use debt within their borrowing ability to avoid or reduce potential negative effects.