Financing
Candlefocus EditorWhen financing a business, there are two main options available: debt financing and equity financing.
Debt financing is the most common form of financing. With debt financing, a business borrows money from a lender, and the loaned funds are used to finance current and future operations. With debt financing, there is a legally binding obligation to repay the borrowed funds, plus interest to the lender. This type of financing typically involves shorter repayment terms and less flexibility. There are several advantages to debt financing, including generally lower costs, tax deductions, and the ability to leverage the money to achieve better returns. A major downside to debt financing is the risk of default, which could lead to penalties, higher debt burdens, and increased credit risks.
Equity financing is the other main form of financing. In equity financing, funds are acquired through the sale of company shares to investors instead of through loans. This type of financing is often offered in the form of initial public offerings (IPOs) or private placements. Equity financing does not carry the same risks as debt financing and does not come with the obligation to repay the funds. The main disadvantage of equity financing is that companies tend to incur a much larger cost, due to the dilution of ownership or the giving up of potential profits for the investor.
No matter the type of financing chosen, the weighted average cost of capital (WACC) is an important metric to consider. The WACC is the average cost of financing a company’s operations, investments, and purchases, and it can help businesses understand the total cost of their financing. It combines the rates of each type of financing and reflects the proportion of each type being utilized.
In summary, there are two main types of financing – debt financing and equity financing – and each has its own advantages and disadvantages. The right type of financing for a business can be determined by its WACC and an understanding of the different risks associated with each type of financing. By evaluating the business’s needs and its WACC, companies can find the most cost-effective way to finance operations, purchases, and investments.