Debt vs. Equity Tutorial: How to Advise Companies on Financing (2024)

If you have an upcoming case study where you have to analyze a company’s financial statements and recommend Debt or Equity, how should you do it?

SHORT ANSWER:

All else being equal, companies want the cheapest possible financing. 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.
But there are also constraints and limitations on Debt – the company might not be able to exceed a certain Debt / EBITDA, or it might have to keep its EBITDA / Interest above a certain level.

So, you have to test these constraints first and see how much Debt a company can raise, or if it has to use Equity or a mix of Debt and Equity.

The Step-by-Step Process

Step 1: Create different operational scenarios for the company – these can be simple, such as lower revenue growth and margins in the Downside case.

Step 2: “Stress test” the company and see if it can meet the required credit stats, ratios, and other requirements in the Downside cases.

Step 3: If not, try alternative Debt structures (e.g., no principal repayments but higher interest rates) and see if they work.

Step 4: If not, consider using Equity for some or all of the company’s financing needs.

Real-Life Example – Central Japan Railway

The company needs to raise ¥1.6 trillion ($16 billion USD) of capital to finance a new railroad line.

Option #1: Additional Equity funding (would represent 43% of its current Market Cap).

Option #2: Term Loans with 10-year maturities, 5% amortization, ~4% interest, 50% cash flow sweep, and maintenance covenants.

Option #3: Subordinated Notes with 10-year maturities, no amortization, ~8% interest rates, no early repayments, and only a Debt Service Coverage Ratio (DSCR) covenant.

We start by evaluating the Term Loans since they’re the cheapest form of financing.

Even in the Base Case, it would be almost impossible for the company to comply with the minimum DSCR covenant, and it looks far worse in the Downside cases

Next, we try the Subordinated Notes instead – the lack of principal repayment will make it easier for the company to comply with the DSCR.

The DSCR numbers are better, but there are still issues in the Downside and Extreme Downside cases.

So, we decide to try some amount of Equity as well. We start with 25% or 50% Equity, which we can simulate by setting the EBITDA multiple for Debt to 1.5x or 1.0x instead.

The DSCR compliance is much better in these scenarios, but we still run into problems in Year 4.

Overall, though, 50% Subordinated Notes / 50% Equity is better if we strongly believe in the Extreme Downside case; 75% / 25% is better if the normal Downside case is more plausible.

Qualitative factors also support our conclusions.

For example, the company has extremely high EBITDA margins, low revenue growth, and stable cash flows due to its near-monopoly in the center of Japan, so it’s an ideal candidate for Debt.

Also, there’s limited downside risk in the next 5-10 years; population decline in Japan is more of a concern over the next several decades.

Debt vs. Equity Tutorial: How to Advise Companies on Financing (1)

About Brian DeChesare

Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.

Debt vs. Equity Tutorial: How to Advise Companies on Financing (2024)

FAQs

How to tell if a company is financed by debt or equity? ›

Debt financing involves the borrowing of money whereas equity financing involves selling a portion of equity in the company. The main advantage of equity financing is that there is no obligation to repay the money acquired through it.

How should a company choose between debt and equity financing? ›

Purpose of funding: If you need funding for a specific project or purchase, debt financing may be a better option since you can repay the loan over time. Equity financing may be more suitable for long-term growth plans.

How do you differentiate between debt and equity as methods of financing? ›

Debt financing refers to taking out a conventional loan through a traditional lender like a bank. Equity financing involves securing capital in exchange for a percentage of ownership in the business. Finding what's right for you will depend on your individual situation.

Is it better to finance a firm with more debt or more 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.

How do you tell how a company is financed? ›

Analyze the Cash Flow Statement

The cash flow statement provides detailed insights into how a company used its cash during an accounting period. It shows the sources of cash flow and different areas where money was spent, categorized into operations, investing, and financing activities.

Why would a company choose debt instead of equity financing? ›

Many fast-growing companies would prefer to use debt to support their growth, rather than equity, because it is, arguably, a less expensive form of financing (i.e., the rate of growth of the business's equity value is greater than the debt's borrowing cost).

What are five differences between debt and equity financing? ›

Debt finance requires no equity dilution, but the business must “pay” for this benefit via interest on top of the initial sum. Equity finance doesn't require the payment of any interest, but it does mean sacrificing a stake in the business and ultimately a share of future profits.

What is pecking order theory in finance? ›

Pecking Order Theory suggests a hierarchical order in which businesses utilize three types of financing: internal funds, debt, and equity to fund investment opportunities. To fund operations, companies first utilize internal funds, such as earnings. If these funds are low, companies turn to debt, such as loans.

What are the 4 main differences between debt and equity? ›

Difference Between Debt and Equity
PointsDebtEquity
RepaymentFixed periodic repaymentsNo obligation to repay
RiskLender bears lower riskInvestors bear higher risk
ControlBorrower retains controlShareholders have voting rights
Claims on AssetsSecured or unsecured claims on assetsResidual claims on assets
6 more rows
Jun 16, 2023

What are three questions financial managers ask when considering long-term financing? ›

What are three questions financial managers ask when considering long-term financing? What sources of long-term funding (capital) are available, and which will best fit our needs? How much long-term funding will be needed to meet the monthly payroll? What are the organization's long-term goals and objectives?

What is a good debt to equity ratio? ›

A good debt to equity ratio is around 1 to 1.5. However, the ideal debt to equity ratio will vary depending on the industry because some industries use more debt financing than others.

What is the most obvious difference between debt and 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.

What is a disadvantage of equity financing? ›

Equity Financing also has some disadvantages as compared to other methods of raising capital, including: The company gives up a portion of ownership. Leaders may be forced to consult with investors when making a decision. Equity typically costs more than debt financing due to higher risk.

When should a start-up use equity versus debt financing? ›

Equity financing might be the right funding instrument for your startup if you need significant capital but don't want the pressure of immediate repayment. It's also helpful when you want to bring on mentors and strategic partners to leverage their knowledge and connections.

Can you see if a company is in debt? ›

Balance Sheet Test: Determines whether a company's assets are worth less than it's liabilities. You should seek advice to do a balance sheet test. If a company's liabilities are found to exceed its assets then the business would not be able to cover creditor repayment in the event of the business being sold.

How do you know if a company is in debt? ›

You can find total liabilities and assets on the balance sheet of the company. This ratio will give you an understanding of the percentage of the company's assets that were funded by incurring debt.

References

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