Day Trading & Forex Forum

kagein

why is obtaining debt cheaper than issuing equity?

If a company has net cash on their balance sheet with no debt, is this a bad thing?

TheBramble

These are two separate questions. A company with net cash balance would not normally be considering raising finance through either debt or equity, why would they? There might be other questions from shareholders regarding a relatively large net cash position (as in why it isn't the cash being utilised more fully), but that is as I say, another question altogether.

Debt can be a cheaper option than equity financing based on the mechanics of measuring the cost of obtaining capital. It’s a comparison of cost of debt with claim on earnings.

Say you need £100K. You can either take out a loan (debt) at a 10% interest rate or sell a lump of your equity (equity financing) say 10% for £100K.

Whatever your profit over he next year (let’s say it’s £500K), you need to take out either the cost of your interest payments on your debt (£10K) leaving you a net profit of £490K or a debt-free, but lower net profit £450K (the 90% of the £500K you still have).

The point at which one method is better than the other is determined by the interest rate you can borrow at, the percentage of equity you would have to assign to obtain equality with the debt amount required and the estimated earnings.

A lower interest rate favours debt, a lower percentage equity rate favours equity and a lower estimated earnings favours equity.