The managers of a corporation and owners of a business always have the option to choose between debt and equity financing. For any business or company, there is always an optimal debt to equity ratio that best achieves the goals of business owners and managers and which depends on a number of factors. Debt financing is the borrowing of money from an outside source preferably a bank with the assurance to return the principal amount in addition to an agreed upon level of interest. Equity financing on the other hand is the cash paid into the business by its owners, or one or more investors contribute their cash into the business.
Equity investments are endorsed by the issuance of company shares. The shares issued are directly proportional to the amount invested by the owners so that the control of the company is in the investor with majority shares worth of investment. The investors contribute their funds into a company with the hope of sharing in its profits and also in the hope that the value of the company stock in the exchange market will appreciate hence increasing their overall net worth (Shim & Siegel, 2000).
The current state of the economy and the financial markets earnings are much more difficult to predict for companies and debt financing is less readily available as a consequence of the conservative lending policies adopted by the banks. The interest rates for spreads for most of the companies have generally increased meaning that the real cost of debt financing after adjustment for inflation has also increased. In today’s financial world market, strengthening the balance sheet of a company with a healthy dose of equity is an option that majority of owners and managers should put into consideration.
Strong banks such as HSBS are raising equity even though they are not undercapitalized. Equity financing could also be used as a financial protection in times of hard financial crisis like in the current economy and financial markets to caution against the deepening of the crisis in case the much anticipated recovery does not occur as expected.
The greatest advantage of equity financing is that it is not repayable unlike debt financing (Shim & Siegel, 2000). This in itself is an advantage for many companies during a financial turmoil since the profits made and slow company growth does not affect the investors as much unlike debt financing that increases the future costs of borrowing and increases debt adding onto the risks for the company. In effect, debt financing causes severe penalties for the business in case of default or late payments and may cause the company to lose all its possessions in case of failure to repay debts in the long run. It is during such times of debt default of payments, that equity financing is preferred by major businesses and companies.
With the current upsurge in stock prices, it is only equity financing that can help a company grow by generating more money into the business unlike repaying company debts that are not worthwhile. Equity financing is and will remain the best option for owners and managers of businesses during hard economic and difficult financial market times. Equity financing is hence desirable compared to debt financing.