Business Financing and the Capital Structure

Student’s Name

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Debt and Equity Financing

Debt and equity financing are the most common sources of capital in business. Most businesses prefer to use both financing methods to enable reduction of downsides of the other. Debt financing is short term costs and obligations where one will retain full ownership of your business. This is mainly borrowing money from creditors. Advantages of debt financing are: It if finite and payment of debt is over time without any obligation to lender. It is also tax deductible on interest on the short term or long-term loan. Disadvantage: Money must be paid back within a fixed duration. Assets of the business can be collateral to the lender. (Jack D. Glen, Brian Pinto, 1994)

Equity financing is a long term investment and the investors hold an ownership interest in the assets. The benefit is that money is given in exchange for equity in business of stock. Advantage of Equity financing: Business owner focuses on profit making rather than loan repayment. It’s less risky than loan as there is no requirement to pay back investors thus can channel profits into expanding the business. Disadvantage: The investors will demand for ownership interest and for any decision made you will have to consult them.

An investment banker can provide leverage and help sell your business .An investment banker helps a company raise significant capital for business owner and assist in propelling a company into the next stage. In selecting an investment banker we should look at their expertise which market sector they specialize in, their experience and relationship because you are entrusting him to sell your business.

Risks and return for common stock versus corporate bonds

Investing in stocks or bonds requires you to know about the issuing entity whether corporate or government. The issuer should have a good financial performance in which one can evaluate through bond ratings and annual reports. All investors believe the higher the returns on an investment the higher the risks are. (Justin Longnecker, J Petty, Leslie Palich and Frank Hoy, 2013)

Common stocks are considered to be an equity investment; companies sell or issue stock to raise capital to fund a business. Corporate bonds are debt instruments the issuer uses to borrow money and they are issued by companies representing larger bond markets. Corporate bonds have less risk than common stock, because the price of bonds isn’t likely to increase unless interest rates fall. When company’s earnings grow the common stock will rise over time and a reduced rating will usually cause bonds price to fall. Bonds help diversify an investment portfolio and reducing the risk e.g. a blue chip bond is a very low risk investment that provides good income.

Bonds are rated based on risks but common stock carry greater risk because holders are last to be paid in case of bankruptcy. Bond holders have the lowest risk and have a stronger claim to payment than common stock holders.

Diversifying the portfolio of investments reduce the risk of a sudden unexpected outcome, this assists when a loss in one investment maybe offset by a gain in another investments. A portfolio should be spread among many different investments such as assets e.g. real estate’s or even stocks. Securities should vary in risk by picking different investments with difference in returns ensuring that large gains offset losses in other areas. Diversification reduces risk taken by an investor but it does not lower risk of underlying securities and it’s difficult to reduce risk of securities.

Reference

Justin Longnecker, J Petty, Leslie Palich and Frank Hoy (2013) Small business management

(17 ed., pp. 144-256) Cengage Learning

Jack D. Glen, Brian Pinto. (1994). Debt or equity: How firms in developing countries choose. (pp. 3-27). Washington Dc: world Bank publication.