where kd cost of debt
since the interest on the debt is tax deductible in most cases the interest expense is calculated on an after tax basis to make it more comparable to the cost of equity as earnings on stocks are taxed one metric used to measure and compare how much of a company s capital is being financed with debt financing is the debt to equity ratio d e for example if total debt is 2 billion and total stockholders equity is 10 billion the d e ratio is 2 billion 10 billion 1 5 or 20 this means for every 1 of debt financing there is 5 of equity in general a low d e ratio is preferable to a high one although certain industries have a higher tolerance for debt than others both debt and equity can be found on the balance sheet statement creditors tend to look favorably on a low d e ratio which can increase the likelihood that a company can obtain funding in the future other types of debt financingin addition to just issuing a bond here is a list of the more common types of debt financing note that some options may be harder for small businesses to secure especially if they haven t been in operations for long or if their financial position is not as strong as larger companies debt financing vs interest ratessome investors in debt are only interested in principal protection while others want a return in the form of interest the rate of interest is determined by market rates and the creditworthiness of the borrower higher rates of interest imply a greater chance of default and therefore carry a higher level of risk higher interest rates help to compensate the borrower for the increased risk in addition to paying interest debt financing often requires the borrower to adhere to certain rules regarding financial performance these rules are referred to as covenants debt financing can be difficult to obtain however for many companies it provides funding at lower rates than equity financing particularly in periods of historically low interest rates another advantage to debt financing is that the interest on the debt is tax deductible still adding too much debt can increase the cost of capital which reduces the present value of the company debt financing vs equity financingthe main difference between debt and equity financing is that equity financing provides extra working capital with no repayment obligation debt financing must be repaid but the company does not have to give up a portion of ownership in order to receive funds most companies use a combination of debt and equity financing companies choose debt or equity financing or both depending on which type of funding is most easily accessible the state of their cash flow and the importance of maintaining ownership control the d e ratio shows how much financing is obtained through debt vs equity creditors tend to look favorably on a relatively low d e ratio which benefits the company if it needs to access additional debt financing in the future advantages and disadvantages of debt financingone advantage of debt financing is that it allows a business to leverage a small amount of money into a much larger sum enabling more rapid growth than might otherwise be possible another advantage is that the payments on the debt can be tax deductible debt financing also allows businesses to retain ownership and control unlike equity financing where ownership stakes are sold to investors the business owners do not have to give up any control or decision making power in the company like we talked about earlier debt financing can be more cost effective compared to equity financing additionally once the debt is repaid the relationship with the lender ends and there are no further obligations in contrast equity investors typically expect ongoing dividends and a share of the profits which can be more expensive in the long run the only way to extinguish this is through share reacquisition the main disadvantage of debt financing is that interest must be paid to lenders which means that the amount paid will exceed the amount borrowed payments on debt must be made regardless of business revenue and this can be particularly risky for smaller or newer businesses that have yet to establish a secure cash flow high levels of debt can negatively impact a company s balance sheet and financial ratios this can make the business appear riskier to investors and lenders potentially leading to higher borrowing costs in the future high debt levels can also limit a company s flexibility as much of its revenue will be tied up in servicing debt also debt financing often involves restrictive covenants lenders may impose conditions that restrict additional borrowing dictate certain financial ratios that must be maintained or limit the types of investments or expenditures a company can undertake this is a risk management strategy to make sure the lender has security in how the company is being run debt financing allows a business to leverage a small amount of capital to create growthdebt payments are generally tax deductiblea company retains all ownership controldebt financing is often less costly than equity financinginterest must be paid to lenderspayments on debt must be made regardless of business revenuedebt financing can be risky for businesses with inconsistent cash flow