What is debt financing?
Debt financing occurs when a business raises money for working capital or capital expenditures by selling debt securities to individuals and / or institutional investors. In exchange for lending the money, individuals or institutions become creditors and receive the promise that the principal and interest on the debt will be repaid.
The other way to raise capital on the debt markets is to issue shares as part of a public offering; this is called equity financing.
Break down debt financing
When a business needs money through financing, there are three ways it can get financing: equity, debt, or a hybrid of the two. Equity represents an interest in the company. It gives the shareholder a claim on future profits, but it does not need to be reimbursed. If the company goes bankrupt, the shareholders are the last to receive the money. The other route a business can take to raise capital for its business is to issue debt – a process known as debt financing.
Debt financing occurs when a business sells fixed income products, such as bonds, bills or notes, to investors to obtain the capital necessary to grow and expand its operations. When a company issues a bond, the investors who buy the bond are lenders who are individual or institutional investors who provide the company with debt financing. The amount of the investment loan, called principal, must be repaid on an agreed date in the future. If the business goes bankrupt, the lenders have a higher claim on the liquidated assets than the shareholders.
Cost of debt financing
The capital structure of a company is made up of equity and debts. The cost of equity corresponds to the payment of dividends to shareholders and the cost of debt to the payment of interest to bond holders. When a company issues a debt, not only does it promise to repay the principal, but it also undertakes to compensate its bondholders by paying them annual interest, called coupons. The interest rate paid on these debt securities represents the cost of borrowing for the issuer.
The sum of the cost of equity financing and debt financing is the cost of capital for a business. The cost of capital represents the minimum return that a business must earn on its capital to satisfy its shareholders, creditors and other providers of capital. A company’s investment decisions regarding new projects and operations should always generate returns above the cost of capital. If the return on capital expenditure is lower than its cost of capital, the business does not generate positive profits for its investors. In this case, the company may need to reassess and rebalance its capital structure.
The cost of debt financing formula is as follows:
Kre = Interest charges x (1 – Tax rate)
where Kre = cost of debt
Since interest on debt is tax deductible in most cases, interest expense is calculated after tax to make it more comparable to the cost of equity because equity earnings are taxed.
Measuring debt financing
A metric used by analysts to measure and compare the proportion of the capital of a company financed by debt financing is the debt / equity ratio, or D / E ratio. For example, if the total debt is 2 billion dollars and total equity of $ 10 billion, the D / E ratio is $ 2 billion / $ 10 billion = 1/5, or 20%. This means that for every dollar of debt financing, there is $ 5 of equity. In general, a low D / E ratio is preferable to a high ratio, although some industries have a higher debt tolerance than others. Both debt and equity appear on the balance sheet.
Interest rate on debt financing
Some indebted investors are only interested in capital protection, while others want a return in the form of interest. The interest rate is determined by market rates and the creditworthiness of the borrower. Higher interest rates imply a higher chance of default and, therefore, a higher level of risk. Higher interest rates help compensate the borrower for the increased risk. In addition to paying interest, debt financing often requires the borrower to follow certain rules regarding financial performance. These rules are called restrictive covenants.
Debt financing can be difficult to obtain, but for many companies, it provides financing at lower rates than equity, especially in periods of historically low interest rates. Another advantage of debt financing is that the interest on the debt is tax deductible. Yet adding too much debt can increase the cost of capital, which reduces the present value of the business.