This infrastructure makes debt easy to account for: you know your repayment obligations ahead of time and you can plan for them. In addition, debt financing may offer its own hidden benefits.
Here are five reasons not to be skittish about financing your company with debt. Entrepreneurs tend to think of VC as free money.
In fact, if you plan to scale and exit, debt is almost always the cheaper option. Think of it this way. Assuming your company is out of the red, debt financing provides a few tax perks that equity financing cannot. If your business uses accrual accounting, the interest portion of your payment runs through your profit and loss statement, which reduces your taxable net income. This means the effective cost of the borrowing is less than the stated rate of interest. Essentially, the US government helps mitigate the cost of your loan.
Taking on equity investors means giving them seats on your board. Will management be willing to raise funds in that manner? If not, is management prepared to change its product-market strategies or dividend policy? Answers to this set of questions can help CFOs arrive at sound decisions regarding capital structure and effectively communicate them to other top managers. But limits to the payoff from using debt do indeed exist. The problem for CFOs is, therefore, to identify the point at which the incremental risks of financial distress more than offset the incremental benefits of the interest tax shield.
Financial statements of many American companies, however, reveal a heavier reliance on debt than is justified by the payoff from the tax deductibility of interest. Why so? Among these conditions:. It would also need to seek new equity less often and so could tap the market on more favorable terms. Especially given the many-sided appeal of debt financing, good two-way communication between CFOs and the rest of top management is essential.
As too many businesses have learned the hard way, the time to build financial reserves is when things are going well. Correcting an unduly aggressive use of debt is always painful, but especially so if that adjustment must be made under duress. Robert S. Ronald W. Jerold B. See Jay O. Light and William L. Irwin, for a full discussion of the forces influencing the rules that govern decisions in the major institutions and the impact of such rules on pricing of securities in financial markets.
See Morton Backer and Martin L. Their three-year study explores the marked differences in the financial ratios various lenders use to assess creditworthiness. For a discussion of the determinants of share prices, see Thomas R. Piper and William E. Fruhan, Jr. You have 1 free article s left this month. You are reading your last free article for this month. Subscribe for unlimited access. Create an account to read 2 more. Finance and investing. Corporate and personal tax rates, which of course vary from situation to situation, significantly affect the attractiveness of […] by Thomas R.
Piper and Wolf A. Exhibit III Impact of debt on total distributable funds. Impact of Financial Leverage on Company Value Assume a company with expected constant earnings before interest and taxes out to infinity and with a policy of distributing all of its earnings as dividends. The present value of an annual flow of iD [ 1 — T pi — 1 — T c 1 — T pe ] to infinity, at a rate equal to i 1 — T pi , is Equation Exhibit IV Corporate financial system. Exhibit VI Financial leverage and sustainable sales growth.
A version of this article appeared in the July issue of Harvard Business Review. Read more on Finance and investing or related topic Costing. Piper is professor of corporate finance at the Harvard Business School. His many publications include a series of jointly authored studies of the investment strategies of large financial institutions under the inflationary conditions of the late s.
Weinhold divides his time between research at the Harvard Business School and management consulting on issues involving corporate strategy, industrial organization, and financial economics.
Partner Center. What are Equity Funds? What are Debt funds? Invests in equities or equity related instruments, like derivatives Return on Investment Low to moderate compared to equity funds Relatively higher returns compared to debt funds in the long term Risk Appetite Low to moderate risk Moderately high to high risk Expenses Expense ratio of debt und is much lower compared to equity funds Equity fund expense ratio is much higher if you compare equity vs debt funds Timings Timing of buy sell is not that important.
Duration of investment is more important in debt funds Timing of buy sell of equities is very important as stock market is very dynamic and may be very volatile at times Suitability Debt funds give you investment option from 1 day to many years with lower to moderate risk.
It can be used as alternate to fixed deposits and savings bank account Equity funds are for long term and suitable to investors with moderately high to high risk appetite.
Equity funds may help reach your long term financial goals Taxation Debt funds held for less than 36 months are taxed as per the income tax rate of the investor. Conclusion In this article, we discussed the difference between equity fund and debt fund and also the characteristics of these funds.
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Thank you sharing your details. We will email you the cobranding collateral shortly. Timing of buy sell is not that important. Duration of investment is more important in debt funds. Timing of buy sell of equities is very important as stock market is very dynamic and may be very volatile at times.
Debt funds give you investment option from 1 day to many years with lower to moderate risk. It can be used as alternate to fixed deposits and savings bank account. Equity funds are for long term and suitable to investors with moderately high to high risk appetite.
Equity funds may help reach your long term financial goals.
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