Every business needs capital to operate successfully. Capital is the money a business—whether it's a small business or a large corporation—needs and uses to run its day-to-day operations. Capital may be used to make investments, conduct marketing and research, and pay off debt.
There are two main sources of capital companies rely on—debt and equity. Both provide the necessary funding needed to keep a business afloat, but there are major differences between the two. And while both types of financing have their benefits, each also comes with a cost.
Below, we outline debt and equity capital, and how they differ.
Key Takeaways
- Debt and equity capital both provide businesses money they need to maintain their day-to-day operations.
- Companies borrow debt capital in the form of short- and long-term loans and repay them with interest.
- Equity capital, which does not require repayment, is raised by issuing common and preferred stock, and through retained earnings.
- Most business owners prefer debt capital because it doesn't dilute ownership.
Debt Capital
Debt capital refers to borrowed funds that must be repaid at a later date. This is any form of growth capital a company raises by taking out loans. These loans may be long-term or short-term such as overdraft protection.
Debt capital does not dilute the company owner's interest in the firm. But it can be cumbersome to pay back interest until its loans are paid off—especially when interest rates are rising.
Companies are legally required to pay out interest on debt capital in full before they issue any dividends to shareholders. This makes debt capital higher on a company's list of priorities over annual returns.
While debt allows a company to leverage a small amount of money into a much greater sum, lenders typically require interest payments in return. This interest rate is the cost of debt capital. Debt capital can also be difficult to obtain or may require collateral, especially for businesses that are in trouble.
If a company takes out a $100,000 loan with a 7% interest rate, the cost of capital for the loan is 7%. Because payments on debts are often tax-deductible, businesses account for the corporate tax rate when calculating the real cost of debt capital by multiplying the interest rate by the inverse of the corporate tax rate. Assuming the corporate tax rate is 30%, the loan in the above example then has a cost of capital of 0.07 X (1 - 0.3) or 4.9%.
Equity Capital
Because equity capital typically comes from funds invested by shareholders, the cost of equity capital is slightly more complex. Equity funds don't require a business to take out debt which means it doesn't need to be repaid. But there is some degree of return on investment shareholders can reasonably expect based on market performance in general and the volatility of the stock in question.
Companies must be able to produce returns—healthy stock valuations and dividends—that meet or exceed this level to retain shareholder investment. The capital asset pricing model (CAPM) utilizes the risk-free rate, the risk premium of the wider market, and the beta value of the company's stock to determine the expected rate of return or cost of equity.
Equity capital reflects ownership while debt capital reflects an obligation.
Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company's profit margins.
Equity capital may come in the following forms:
- Common Stock: Companies sell common stock to shareholders to raise cash. Common shareholders can vote on certain company matters.
- Preferred Stock: This type of stock gives shareholders no voting rights, but does grant ownership in the company. These shareholders do get paid before common stockholders in case the business is liquidated.
- Retained Earnings: These are profits the company has retained over the course of the business' history that has not been paid back to shareholders as dividends.
Equity capital is reported on the stockholder's equity section of a company's balance sheet. In the case of a sole proprietorship, it shows up on the owner's equity section.
FAQs
Equity capital reflects ownership while debt capital reflects an obligation. Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company's profit margins.
What is the difference between debt capital and equity capital? ›
Debt capital often involves the company issuing debentures to investors in exchange for capital. These investors who hold debentures, hold a security, are creditors of the company and are entitled to interest payments. Equity capital, on the other hand, refers to the sale of stock to raise equity.
Why is the cost of debt capital is lower than the cost of equity capital? ›
Well, the answer is that cost of debt is cheaper than cost of equity. As debt is less risky than equity, the required return needed to compensate the debt investors is less than the required return needed to compensate the equity investors.
What is the difference between WACC and CAPM? ›
WACC is the total cost of all capital. CAPM is used to determine the estimated cost of shareholder equity. The cost of equity calculated from the CAPM can be added to the cost of debt to calculate the WACC.
What is the difference between cost of debt and WACC? ›
The cost of capital is the total cost of debt and equity that a company incurs to run its operations. This method doesn't consider the relative proportion of each source of financing. WACC, on the other hand, goes a step further by considering the proportion of each financing source used by the company.
What are the 4 main differences between debt and equity? ›
Difference Between Debt and Equity
| Points | Debt | Equity |
|---|
| Profit Sharing | No sharing of profits | Shareholders receive a share of profits |
| Legal Structure | No impact on legal structure | Equity can affect the legal structure |
| Risk Appetite | More suitable for risk-averse entities | More suitable for risk-tolerant entities |
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Here are some key differences between equity and capital: Equity represents the total amount of money a business owner or shareholder would receive if they liquidated all their assets and paid off the company's debt. Capital refers only to a company's financial assets that are available to spend.
What is the difference between cost of equity and cost of debt capital? ›
Equity capital reflects ownership while debt capital reflects an obligation. Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company's profit margins.
Why is debt always cheaper than equity? ›
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.
What is the cost of debt capital? ›
The cost of debt is the effective rate that a company pays on its debt, such as bonds and loans. The key difference between the pretax cost of debt and the after-tax cost of debt is the fact that interest expense is tax-deductible. Debt is one part of a company's capital structure, with the other being equity.
Cost of Equity vs WACC
The WACC is used instead for a firm with debt. The value will always be cheaper because it takes a weighted average of the equity and debt rates (and debt financing is cheaper).
Is CAPM the same as cost of equity? ›
The CAPM formula is widely used in the finance industry. It is vital in calculating the weighted average cost of capital (WACC), as CAPM computes the cost of equity. WACC is used extensively in financial modeling.
What does the CAPM model tell us? ›
Key Takeaways. The capital asset pricing model, or CAPM, is a financial model that calculates the expected rate of return for an asset or investment. CAPM does this by using the expected return on both the market and a risk-free asset, and the asset's correlation or sensitivity to the market (beta).
What is the WACC for dummies? ›
Weighted average cost of capital (WACC) is a company's average after-tax cost of capital from all sources, including common stock, preferred stock, bonds, and other forms of debt. It represents the average rate that a company expects to pay to finance its business.
How do debt and equity differ in their cost and risk involved? ›
The cost of equity is more than the cost of debt and it is a risky form of investment as the shareholders will only get returns if the company makes a profit, but in the case of debt, the lenders need to be paid a fixed rate of interest for loans.
What is the best capital structure? ›
The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company's market value while minimizing its cost of capital. In theory, debt financing offers the lowest cost of capital due to its tax deductibility.
What is an example of debt capital? ›
Debt capital refers to borrowed funds that must be repaid at a later date, usually with interest. Common types of debt capital are: bank loans. personal loans.
Is debt capital cheaper than equity capital? ›
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.
What are the advantages of equity capital over debt capital? ›
There are many advantages of equity financing, including:
- There is no obligation to repay the money.
- There are no additional financial burdens on the company – since there are no required monthly payments the company has more capital available to invest in growing their business.
With debt finance you're required to repay the money plus interest over a set period of time, typically in monthly instalments. Equity finance, on the other hand, carries no repayment obligation, so more money can be channelled into growing your business.
