Definition: Debt financing occurs when a firm raises money for working capital or capital expenditures by selling debt instruments to individual or institutional investors.
Process: Investors become creditors and have a promise of repayment with interest.
Key Takeaways
Debt financing involves raising money through selling debt instruments.
Opposite of equity financing, which involves issuing stock.
Involves selling bonds, bills, or notes.
Must be repaid, unlike equity financing.
Crucial for small and new companies for growth.
How Debt Financing Works
Companies can finance by selling equity, taking on debt, or a mix.
Equity gives shareholders a claim on future earnings but no repayment is needed.
Debt involves selling fixed-income products like bonds.
In bankruptcy, creditors have higher claims than shareholders.
Special Considerations
Cost of Debt
Capital Structure: Composed of equity and debt.
Cost of Debt: Interest payment to bondholders, known as coupon payments.
Cost of Capital: Sum of cost of equity and cost of debt.
Formula: KD = Interest Expense x (1 - Tax Rate)
Interest is typically tax-deductible.
Measuring Debt Financing
Debt-to-Equity Ratio (D/E): Measures how much capital is financed with debt.
Low D/E ratio is generally preferred.
Other Types of Debt Financing
Term Loans: Lump sum from a bank with fixed/variable rates.
Lines of Credit: Flexible loan usable as needed.
Revolving Credit Facilities: Larger, for substantial businesses.
Equipment Financing: For purchasing business-critical equipment.
Merchant Cash Advances: Lump sum in exchange for a percentage of future sales.
Trade Credit: Short-term financing from suppliers.
Convertible Debt: Loans convertible to equity shares.
Debt Financing vs. Interest Rates
Investors may seek principal protection or interest return.
Interest rates based on market and borrower creditworthiness.
High rates imply higher risk and potential default.
Debt Financing vs. Equity Financing
Debt Financing: Must be repaid, retains ownership.
Equity Financing: No repayment, but ownership stake given up.
Companies use a mix based on accessibility, cash flow, and ownership control.
Advantages and Disadvantages of Debt Financing
Pros of Debt Financing
Leverage small capital for growth.
Tax-deductible payments.
Retain ownership.
Often less costly than equity financing.
Cons of Debt Financing
Interest payments required.
Payments regardless of revenue.
Can be risky for businesses with poor cash flow.
Possible restrictive covenants from lenders.
Examples of Debt Financing
Includes bank loans, family/friend loans, SBA loans, lines of credit.