Comparison Between Debt And Equity

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Table of Contents

Introduction
Equity
Pros Of Issuing New Shares
Cons Of Issuing New Shares
Debt
Advantages of Debt
Disadvantages Of Debt
Conclusion
References

Introduction

Briarwood Medical Equipment (BME), is facing a dilemma of raising capital for its expansion needs. Given that they need to raise an amount of $250 thousand to finance the expansion and the options available, which are raising new shares and obtaining external sources of finance. It appears that they would have to settle for a hybrid between equity and debt. This paper, therefore, seeks to analyze the pros and cons of raising capital through equity and debt.

Equity

Equity is the share capital and retained earnings (Investopedia, 2011). In the case of BME that would be the value of its shares. The case scenario illustrates that BME can only raise 49 percent of its expansion financial requirements by issuing 125,000 new shares valued at $1each. Though this is still insufficient to fully cater to the expansion budget, issuing a new share has pros and cons attached to it.

Pros Of Issuing New Shares

Issuing new shares allows the firm to acquire debt they are not legally obliged to pay back. They would also raise this type of capital without the need for collateral; unlike bank loans that require collateral. The firm is also not obliged to pay dividends but would do so of their own volition. This would enable the firm to buy time in making payments and use the money they would otherwise have to pay lofty interest rates for internal strengthening and expansion (Holmen M et al., 2008).

Cons Of Issuing New Shares

The cost of equity faces a myriad of uncertainty. This is because its dividends are pegged on the profits available. In times when the firm is performing very well, the dividend expected may be higher than the external cost of sourcing capital which has fixed interest rates. Issuing new shares also dilutes the ownership of the company as additional owners come on board. And issuing new shares may be costly as it entails advertisements cost and high administration expenses related to issuing new shares.

Debt

Debt may include bank loans and debentures issued against specific company assets and loans from financial institutions. In the case of BME, it has to raise 51 percent of its capital requirements through external sources. This like the case with shares has its share of advantages and disadvantages.

Advantages of Debt

Debt usually carries a fixed interest rate and is not subject to uncertainty. For a firm that has strong liquidity history, acquiring debt may be an easy option and given that its risk of default is lower, it maybe is able to negotiate a lower interest rate. Acquiring this type of finance would also be cheaper as it involves just requesting a viable institution or making a single application. Also having debt and paying it promptly increases the firms credit rating and the firm may use this good rating to negotiate larger loans at better rates in the future (Das, 2011).

Disadvantages Of Debt

Debt carries fixed rates and fixed payment dates. Failure to comply may have devastating effects. These effects include the firm suddenly having a poor credit rating. It may also face the risk of bankruptcy and liquidation. In case of one single default, loan payment the fines may be dear and the cost of debt may even exceed the initial amount borrowed.

Conclusion

The selection of choice between raising debt and equity is dependent on the inherent circumstances. In the case of BME, it would have to settle for both options to raise its intended capital.

References

Das B., (2011). Business Studies. The merits and demerits of equity shares as a source of finance. Web.

Holmen M et al., (2008). Inside shareholders effective tax rates and dividends. Web.

Investopedia, (2011). Equity. Web.

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