X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2019 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Equity or Debt: Which is cheaper? - Views on News from Equitymaster

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

Equity or Debt: Which is cheaper?

Oct 13, 2010

Put yourself in the shoes of the CFO of a company. One major aspect you will be confronted with in your job will relate to the financing of your company's assets. Just like a plant needs water to grow, businesses need capital in order to expand. For this you have two basic choices, go to a bank and ask for a loan or sell a stake in your company to raise capital. Basically issue either debt or equity.

As a prudent CFO, you would be ideally looking for the cheapest source of finance. So as a general rule, which source is cheaper, debt or equity?

Well with all the IPOs doing the round these days, you must be thinking that equity is the cheaper source of finance. After all, promoters are just selling a small portion of their business. And with Indian share markets currently at lofty valuations, it may be a lot easier to get a handsome bargain. Some promoters even take on additional equity to pay off their debt lenders. So equity seems cheaper, right?

However, debt is actually the cheaper source of finance for a couple of reasons.

  • Tax benefit: The firm gets an income tax benefit on the interest component that is paid to the lender. Dividends to equity holders are not tax deductable.

  • Limited obligation to lenders: In the event of a firm going bankrupt, which is what happened with Lehman Brothers, equity holders lose everything. But, debt holders have the first claim on company assets (collateral), increasing their security. So since debt has limited risk, it is usually cheaper. Equity holders are taking on more risk, hence they need to be compensated for it with higher returns.

  • Limited upside: Since the equity holder has a stake in the business; he can actually participate in the potential upside in earnings. PE, Venture Capital funds usually buy stakes in high potential companies at cheap valuations, and since they have a minority stake in the company, they are entitled to a share of the profits. Plus they can exit after a few years at a fantastic premium. On the other hand debt holders have an upside limited to the fixed rate of interest they receive every year.
However, taking on debt financing, though cheaper is not without risks for the firm taking on the debt (borrower). Or taking on debt may not be suitable in certain situations.
  • There is limited risk for the lender, but high risk for the borrower. This is because the debt needs to be serviced i.e. principal and interest repayments need to be made, irrespective of whether the firm is making a profit or a loss or general economic conditions. Firms with large debt balances during the economic crisis, felt tremendous pressure.

  • Taking on debt can be beneficial till a certain point. But when the company becomes over-leveraged, the cost of raising additional debt becomes more and more expensive. This is because the earlier lenders would have laid the first claim on the company's assets. The subsequent lenders will thus charge more interest as the lending becomes riskier. Credit ratings also deteriorate as more and more debt capital is raised.

  • We often hear of massive amounts being raised through some IPOs. Coal India plans to raise US$ 3 bn. Petrobas in Brazil, raised US$ 70 bn in the world's largest IPO, recently. These companies can afford to raise this kind of money as the risk is relatively diversified among a large group of investors. A bank or even a group of banks would never lend such huge amounts to one borrower.
Now you know that debt is usually a cheaper source of finance than equity, but not always the case. So next time if you see debt on the balance sheet of a company you are looking at investing in, don't be too alarmed. If the quantum of debt is not too high and it is taken at cheap rates then it is a good, cheap alternative. The company's return on equity can even be enhanced through leverage.

However, this does not mean that taking on debt is suitable for all companies. And risks of over-leveraging are always there. Too much of a good thing is usually bad.


Equitymaster requests your view! Post a comment on "Equity or Debt: Which is cheaper?". Click here!

  

More Views on News

BSE Sensex Surges 571 Points; BHARTI AIRTEL Among Top Gainers (Market Updates)

May 24, 2019 | Updated on May 24, 2019

Markets all time high analysis : The BSE Sensex Surged 571 Points; BHARTI AIRTEL Among Top Gainers. Find the latest update, special reports and news on all time high gainers of BSE Sensex at equitymaster.com.

How Millennials Should Go About Building a Mutual Fund Portfolio (Outside View)

May 24, 2019

PersonalFN explains how millennials can build a mutual fund portfolio.

Should You Consider Dividend Yield Funds Given The Turbulence Ahead? (Outside View)

May 24, 2019

Dividend yield funds not only invest in dividend yielding stocks, but they try to maximise the dividend yield by buying good dividend paying companies at cheap valuations.

5 Reasons Why the Markets Fell Despite an Overwhelming Modi Victory (Profit Hunter)

May 24, 2019

Here's why I believed market would fall after the results were announced despite a massive Modi victory.

After Modi's Win, These Stocks Picked by India's Top Investors Are Poised for Big Gains (The 5 Minute Wrapup)

May 24, 2019

Here's how you can profit from the stock markets after Modi's historic win in the elections.

More Views on News

Most Popular

Risk Management in Trading

Risk management is an essential but often overlooked prerequisite to successful active trading.

My Top 7 Stocks to Profit from Sensex 100,000(The 5 Minute Wrapup)

May 16, 2019

Tanushree Banerjee explains everything you need to know about the Rebirth of India and Sensex 100,000.

3 Stocks to Bet on to Become a 'Dividend Millionaire'(Profit Hunter)

May 14, 2019

As markets continue to rattle amid earning season, upcoming elections, volatile crude price and US China trade war, it's a great idea to add some stability to your portfolio by adding dividend stocks.

Indian Steel: The Perfect Multibagger Opportunity(Profit Hunter)

May 17, 2019

A structurally strong Indian Steel Industry will help India achieve 8%+ GDP growth in the coming years.

What Makes TVS Srichakra and CCL Products a Cut Above the Rest?(The 5 Minute Wrapup)

May 17, 2019

Despite the commodity nature of their businesses, these two stocks have rewarded shareholders well.

More

Get the Indian Stock Market's
Most Profitable Ideas

How To Beat Sensex Guide 2019
Get our special report, How to Beat Sensex Nearly 3X Now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


May 24, 2019 (Close)

MARKET STATS