Posted in Finance, Accounting and Economics Terms, Total Reads: 672
There are different options available to a company for its financing needs. All those options are categorized under debt and equity. Debt financing refers to any borrowed money which the company pays back to the lending institution. It can come in the form of a loan, line of credit, and bond. Financing obtained through issuance of common or preferred stock to individual or institutional investors is called equity financing. Investors receive an ownership over the company in return of investment. Debt and equity together form the capital structure of the company. A change in the capital structure of the company by swapping debt for equity or vice versa is known as Recapitalization. Companies replace equity with debt when there are projects with positive NPV in the company and they want to get advantage of tax shields. Companies go for equity financing when expected cost of bankruptcy or agency cost is high. Stock market reacts differently to different situation. Stock prices generally go up with more debt as it indicates the confidence of the company. Stock prices tend to go down with issue of more equity and dilution of ownership.
Example: Suppose a company is financed with 50% debt and 50% equity and total capital value is $50 million. If the management senses that there are projects which can provide positive returns in future they may want to change the capital structure and include more debt to get tax shields and avoid profit sharing with multiple investors. They may decide to go for 70% debt and 30% equity financing.