Debt vs Equity Financing (2024)

Comparing the pros and cons of both, and understanding the relationship between WACC and leverage

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Debt vs Equity Financing: Which is Best?

Debt vs Equity Financing – which is best for your business and why? The simple answer is that it depends. The equity versus debt decision relies on a large number of factors such as the current economic climate, the business’ existing capital structure, and the business’ life cycle stage, to name a few. In this article, we will explore the pros and cons of each, and explain which is best, depending on the context.

Definition of terms

From a business perspective:

  • Debt: Refers to issuing bonds to finance the business.
  • Equity: Refers to issuing stock to finance the business.

We recommend reading through the articles first if you are not familiar with how stocks and bonds work.

How does capital structure influence the debt vs equity decision?

To answer this question, we must first understand the relationship between the Weighted Average Cost of Capital (WACC) and leverage. Generally speaking, the best capital structure for a business is the capital structure that minimizes the business’ WACC. As the chart below suggests, the relationships between the two variables resemble a parabola.

Debt vs Equity Financing (1)

At point A, we see a capital structure that has a low amount of debt and a high amount of equity, resulting in a high WACC. At point B, we see the opposite: a capital structure with a high amount of debt and a low amount of equity – which also results in high WACC. In order to minimize WACC, the capital structure must consist of a balanced combination of debt and equity.

Why is too much equity expensive?

The Cost of Equity is generally higher than the Cost of Debt since equity investors take on more risk when purchasing a company’s stock as opposed to a company’s bond. Therefore, an equity investor will demand higher returns (an Equity Risk Premium) than the equivalent bond investor to compensate him/her for the additional risk that he/she is taking on when purchasing stock. Investing in stocks is riskier than investing in bonds because of a number of factors, for example:

  • The stock market has a higher volatility of returns than the bond market
  • Stockholders have a lower claim on company assets in case of company default
  • Capital gains are not a guarantee
  • Dividends are discretionary (i.e., a company has no legal obligation to issue dividends)

Thus, financing purely with equity will lead to a high WACC.

Why is too much debt expensive?

While the Cost of Debtis usually lower than the cost of equity (for the reasons mentioned above), taking on too much debt will cause the cost of debt to rise above the cost of equity. This is because the biggest factor influencing the cost of debt is the loan interest rate (in the case of issuing bonds, the bond coupon rate).

As a business takes on more and more debt, its probability of defaulting on its debt increases. This is because more debt equals higher interest payments. If a business experiences a slow sales period and cannot generate sufficient cash to pay its bondholders, it may go into default. Therefore, debt investors will demand a higher return from companies with a lot of debt, in order to compensate them for the additional risk they are taking on. This higher required return manifests itself in the form of a higher interest rate.

Thus, financing purely with debt will lead to a higher cost of debt, and, in turn, a higher WACC.

It is also worth noting that as the probability of default increases, stockholders’ returns are also at risk, as bad press about potential defaulting may place downward pressure on the company’s stock price. Thus, taking on too much debt will also increase the cost of equity as the equity risk premium will increase to compensate stockholders for the added risk.

Learn more about Warren Buffet’s thoughts on equity vs debt.

Optimal capital structure

The optimal capital structure is one that minimizes the Weighted Average Cost of Capital (WACC) by taking on a mix of debt and equity. Point C on the chart below indicates the optimal capital structure on the WACC versus leverage curve:

Debt vs Equity Financing (2)

If the business is at point A on the curve, issuing debt would bring down its WACC. If the business is at point B on the curve, issuing equity would bring down its WACC. For more details on calculating WACC, click here.

Other factors to consider

Below are other important factors that need to be taken into consideration when making a financing decision:

  • Flotation costs: If investment banks are charging a lot to issue (or “float”) new stock, issuing debt will be cheaper and vice versa.
  • Interest rates: High interest rates will require the business to offer high coupon bonds in order to be an attractive investment. This will be more costly, thus issuing equity will be cheaper and vice versa.
  • Tax rates: High tax rates will deduct from bondholders’ returns as they will need to give more of their coupon away. Thus, they will demand higher returns to compensate. In this case, issuing equity will be cheaper and vice versa.
  • Earnings volatility: If the business is seasonal, or sees volatile revenues each month, it will be difficult to guarantee enough cash will be available for coupon payments. Therefore, issuing equity will be a better decision and vice versa.
  • Business growth: If the company is fairly young and is making significant investments in R&D in order to support growth, it may be wiser to reduce monthly claims on cash flows by issuing equity and vice versa.

The table below easily summarizes the debt vs equity decision:

Debt vs Equity Financing (3)

*Assuming all other factors remain the same

More resources

Thank you for reading this guide on debt vs equity and the pros and cons of each type of financing. To keep learning and advancing your career as an analyst, the following CFI resources will also be helpful:

  • Cost of Debt
  • Cost of Equity
  • Interest
  • PRAT Model
  • See all commercial lending resources
  • See all capital markets resources
Debt vs Equity Financing (2024)


Debt vs Equity Financing? ›

Debt financing means a company takes on debt and borrows from a lender. Equity financing means a company sells shares to investors in exchange for funding. For this type of funding, businesses don't need to pay back any money they get from investors.

Which is better, equity financing or debt financing? ›

Equity financing may be less risky than debt financing because you don't have a loan to repay or collateral at stake. Debt also requires regular repayments, which can hurt your company's cash flow and its ability to grow.

Is it better to rely on debt or equity? ›

‍Key takeaways:

Equity financing is essential to new companies just starting out. But once you have some equity as a startup, leveraging debt financing makes sense. Use both debt and equity together to create an optimal capital structure and make your company more financially stable as you grow.

What should be more debt or equity? ›

Since Debt is almost always cheaper than Equity, Debt is almost always the answer. Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders' expected returns are lower than those of equity investors (shareholders). The risk and potential returns of Debt are both lower.

What happens if you have more debt than equity? ›

The debt-to-equity (D/E) ratio is a metric that provides insight into a company's use of debt. In general, a company with a high D/E ratio is considered a higher risk to lenders and investors because it suggests that the company is financing a significant amount of its potential growth through borrowing.

Why debt financing is the best? ›

One advantage of debt financing is that it allows a business to leverage a small amount of money into a much larger sum, enabling more rapid growth than might otherwise be possible. Another advantage is that the payments on the debt are generally tax-deductible.

Why is debt financing better? ›

Pros of debt financing include immediate access to capital, interest payments may be tax-deductible, no dilution of ownership. Cons of debt financing include the obligation to repay with interest, potential for financial strain, risk of default.

What are the disadvantages of debt financing? ›

  • Qualification requirements. You need a good enough credit rating to receive financing.
  • Discipline. You'll need to have the financial discipline to make repayments on time. ...
  • Collateral. By agreeing to provide collateral to the lender, you could put some business assets at potential risk.

What are the pros and cons of debt financing? ›

The advantages of debt financing include lower interest rates, tax deductibility, and flexible repayment terms. The disadvantages of debt financing include the potential for personal liability, higher interest rates, and the need to collateralize the loan.

What are the pros and cons of debt and equity financing? ›

Cash flow: Equity financing does not take funds out of the business. Debt loan repayments take funds out of the company's cash flow, reducing the money needed to finance growth. Long-term planning: Equity investors do not expect to receive an immediate return on their investment.

When should a company use equity financing? ›

Equity should be used for financing when the risk of not being able to service debt (payment of principal and interest) is high. If you can't repay, don't borrow! The greater the business risk makes equity the better choice for financing. This is the reason why start-ups are typically financed with equity.

In which case should a company go to opt for equity rather than debt? ›

The business is then beholden to shareholders and must generate consistent profits in order to maintain a healthy stock valuation and pay dividends. Since equity financing is a greater risk to the investor than debt financing is to the lender, the cost of equity is often higher than the cost of debt.

Which best states one of the disadvantages of equity financing? ›

  • Share profit. Your investors will expect – and deserve – a piece of your profits. ...
  • Loss of control. The price to pay for equity financing and all of its potential advantages is that you need to share control of the company.
  • Potential conflict.

What are the disadvantages of having more debt than equity? ›

Disadvantages of Debt Compared to Equity
  • Unlike equity, debt must at some point be repaid.
  • Interest is a fixed cost which raises the company's break-even point. ...
  • Cash flow is required for both principal and interest payments and must be budgeted for.

Why do companies use debt financing? ›

Reasons why companies might elect to use debt rather than equity financing include: A loan does not provide an ownership stake and, so, does not cause dilution to the owners' equity position in the business. Debt can be a less expensive source of growth capital if the Company is growing at a high rate.

What is a good equity ratio? ›

Still, as a general rule of thumb, most companies aim for an equity ratio of around 50%. Companies with ratios ranging around 50% to 80% tend to be considered “conservative”, while those with ratios between 20% and 40% are considered “leveraged”.

What is one advantage of equity financing over debt financing? ›

Advantages of Equity Financing

There are no repayment obligations. There is no additional financial burden. The company may gain access to savvy investors with expertise and connections. Company health can improve by decreasing debt-to-equity ratio and credit score.

Is equity financing more risky than debt financing? ›

Debt financing is generally considered to be less risky than equity financing because lenders have a legal right to be repaid. However, equity investors have the potential to earn higher returns if the company is successful. The level of risk and return associated with debt and equity financing varies.


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