Corporate Finance: Issuing Debt Versus Equity

Executives are tasked with structuring corporate finance to meet business objectives through issuing combinations of debt and equity. Alternatively, prospective investors will analyze the strength of corporate balance sheets, in terms of debt levels, equity issued, and operational cash flow, before committing to own shares or lend money to the corporation. Corporations that demonstrate a strong command of balancing debt versus equity are best positioned to grow profits and generate strong returns for investors.

Corporations

Corporations sell equity, or ownership stakes, to investors in the form of shares of stock, in exchange for cash. Investors can first buy into the larger corporations through initial public offerings (IPOs). From there, the shares will trade upon the secondary market – through exchanges like the New York Stock Exchange and Nasdaq. Shareholders maintain claims to the assets and profitability of the corporation, in conjunction with voting rights – to elect a board of directors, who in turn, hire management to run the company.

Creditors lend money to the corporation via debt financing. The corporation makes interest payments on these loans, before returning principal at a predetermined date. Creditors do not vote in business operations, but carry asset claims above shareholders. Creditors will be paid off first amid bankruptcy.

Risks versus Rewards

Debt financing may be categorized further into mortgages, commercial paper, certificates of deposit and bonds. Further, debt financing may be either secured, or unsecured. Unsecured debt relies solely upon good faith within the company to make payments. Secured loans, such as mortgages, are backed by property, which may be seized amid default to make good upon the debt. Creditors demand higher interest rates for loaning money to riskier businesses and projects.

Stock and bond valuations, of course, fluctuate according to business profitability. Stock prices, which may theoretically range between zero and infinity, are typically more volatile than bonds. The volatility in stocks is largely due to the fact that shareholders have little rights relative to bondholders amid bankruptcy.

Dividends and Interest

Corporations pay interest on bonds and dividends on stocks. Interest payments are tax-deductible expenses, which are required to meet loan terms. Dividends, however, are not tax-deductible expenses, as they are paid out of net income to investors. Corporations, of course, are under no obligation to pay dividends.

Mature companies lacking growth opportunities typically return earnings to shareholders through larger dividend payments. Alternatively, growing companies will reinvest capital to finance expansion. Meanwhile, interest rates on bonds are a factor of the underlying corporation’s ability to service debt.

Financial Strategy

Issuing common stock enables the corporation to access capital—without being forced to meet interest expense obligations. Financial managers may also use common stock as currency to buy out other firms. In comparison, debt provides access to capital—without ceding control. Shareholders own the company, not creditors. Debt, of course, increases expenses, which may expose the corporation to default and failure.