Unit 6_ Activity 1 - Debt vs. Equity Financing

Unit 6: Debt vs. Equity Financing

Overview

  • Compare advantages and disadvantages of debt financing and equity financing.

  • Learn about bonds as a method of debt financing.

Debt Financing vs. Equity Financing

  • Corporations need funding beyond their earnings for major projects.

  • Management choices: borrowing money (debt financing) vs. selling ownership (equity financing).

  • Debt Financing: Includes bank loans, notes payable, leasing, issuing bonds.

  • Equity Financing: Involves issuing common or preferred shares.

Choosing a Financing Method

  • Corporations need to decide between debt financing and equity financing based on their requirements.

  • **For Modest Funding: **

    • Bank loans, notes payable, or leasing are preferable.

  • For Large Long-term Funding:

    • Issuing bonds or common shares is necessary.

    • Selling shares gives investors voting rights.

    • Bonds represent long-term liabilities; repayment involves both principal and interest.

Advantages and Disadvantages of Debt Financing

Advantages

  • Shareholder control remains intact (bondholders lack voting rights).

  • Tax efficiency: Bond interest is tax-deductible.

  • Potential for higher earnings per share.

  • Favorable in low-interest rate environments.

Disadvantages

  • Obligated to pay interest periodically.

  • Principal payment required at maturity.

  • High-interest rates can increase overall cost.

Advantages and Disadvantages of Equity Financing

Advantages

  • No obligation to repay principal.

  • No necessity to distribute profits during losses.

  • No claims from third parties on company assets.

Disadvantages

  • Profits are diluted (lower earnings per share).

  • Increased shareholder input may steer management direction.

  • Missed income tax savings because shareholders pay taxes on dividends.

Issuing Bonds

  • Issuer: Corporation that raises funds by issuing bonds.

  • Bondholder: Individual or organization that buys the bond.

  • Details to be provided in bond issuance:

    • Number of bonds, total face value, contractual interest rate.

  • Example: A $1,000 bond priced at 102.56 sells for $1,025.60.

Bond Indenture Document

  • Contains critical information including:

    • Terms of the bond issue.

    • Rights of bondholders and their trustees.

    • Obligations of the issuing company.

  • Follow-up to prepare bond certificates.

Types of Bonds

  • Secured Bonds: Backed by specific assets as collateral vs. Unsecured Bonds: Based on general credit.

  • Term Bonds: Mature on a specified date vs. Serial Bonds: Mature in installments.

  • Registered Bonds: Issued to named bondholder vs. Bearer Bonds: Transferable upon possession.

  • Convertible Bonds: Can be exchanged for shares later.

  • Callable Bonds: Can be redeemed before maturity for a stated amount.

  • Retractable Bonds: Can be redeemed anytime before maturity by the bondholder.

  • Bonds can possess multiple features.