What Is Debt Financing?
Debt financing occurs when a firm raises money for working capital or capital expenditures by selling debt instruments to individuals and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid. The other way to raise capital in debt financing markets is to issue shares of stock in a public offering; this is called equity financing.
How Debt Financing Works
When a company needs money through financing, it can take three routes to obtain financing: equity, debt, or some hybrid of the two. Equity represents an ownership stake in the company. It gives the shareholder a claim on future earnings, but it does not need to be paid back. If the company goes bankrupt, equity holders are the last in line to receive money. The other route is debt financing — where a company raises capital by issuing debt.
Debts Financing vs. Interest Rates
Some 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, 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, but for many companies, it provides funding at lower rates than equity financing, especially in periods of historically low-interest rates. Another perk 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.
Special Considerations Cost of Debt
A firm’s capital structure is made up of equity and debt. The cost of equity is the dividend payments to shareholders, and the cost of debt is the interest payment to bondholders. When a company issues debt, not only does it promise to repay the principal amount, it also promises to compensate its bondholders by making interest payments, known as coupons of payments , to them annually. The interest rate paid on these debt instruments represents the cost of borrowing to the issuer. If you are considering bringing all your debts in one existing debts, kindly talk to us. We will finance your debts at affordable 3% interest rate via a private investor and the security we need to finance your debts is your personal written guarantee for repayment of the loan.
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Real Bridging Finance Ltd