What is debt financing
Debt financing is a scope under economics and a study under business finance which involves the act of lending money out to an individual for starting a business and running a business or corporation with the hope of repaying back with interest. What is Debt financing and it works side by side with equity financing in the capital and business financing. The individual who lent money out is referred to as the creditor while the individual whom money was lent to is referred to as the debtor.
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The debtor collect money for the purpose of souring for funds or raising capital to keep the running of the business or organisation going. The creditor gives the money out to the debtor with the debtor promising to return both the principal and interest. The creditor decides the interest rate base on the amount lent out and the level at which the organisation increases in value.
Sources of debt financing
When an individual needs money for the finance of the company, it might different route in obtaining the financing. It can take the sources of debt financing route or the equity financing route and it might also take the combination of the two in which the company practices both the debt financing strategy and the equity financing strategy. In equity financing, the stakeholders or investors manage the financing of the corporation while the sources of debt financing only have the right to collect the principal and the interest back without having any influence in the running of the individual business.
The creditor can have their money back even if the company goes bankrupt unlike what is equity financing that has the investors always the last to collect their money and if the company goes bankrupt, their money is gone with it. Principal is the money that was paid to the borrower by the lender in running the affairs of the company while interest is the extra money that would be paid by the borrower for borrowing the money from the lender.
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Advantages and disadvantages of debt financing
Getting sources of debt financing can be very difficult to get at times as the interest might be very high because interest rate is usually charge or determined according to market rates. Some investors in debt might only be interested you protecting the principal without collecting the interest while some investors provide funding at lower charge than the equity financing. Another aspect of debt financing is that the interest on the principal can be tax deductible.
When debt is being added and getting higher as the capital for running business, it might at the end be more than the company value making the liability to be higher than the assets. This reduces the total net worth finally leaving the company bankrupt and the borrower will still be in debt as the creditor would still have to collect his money from the debtor as agreed.
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Types of debt financing
As the cost for equity financing is dividends paid to shareholders so also the cost for debt financing is interest paid to bondholders. The company pay a particular amount of money known as coupon payment. This coupon payment is different from the principal which must always be paid back after the debt has been issued. The interest rate represents the cost of borrowing which is usually given to the issuer and these interest rates are paid on debt instruments.
Both the equity and debt make up the capital structure of a firm or corporation. The corporation have cost of capital and this is calculated by adding the cost of what is debt financing and equity financing. The cost of capital is the money that must be earned by the company to satisfy its bondholders, creditors and other individuals that involve in the raising of capital for the finance of the company.
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The company worth is got from the subtraction of cost of capital from the total income of the company. If the cost of capital is greater than the total income, there is a high chance of the company going bankrupt. So whatever the business the company is involve in or the investment of the company should always generate money or returns greater than the cost capital of starting or running the company.