Equity or debt? All businesses that need financing will do so in these two forms. There are however some large companies that have managed to totally become debt-free. Some examples are Google, Amazon, and Apple.
When you hear that these companies have no debt, it sounds like a great deal. But is it really that good? Ask any finance manager and he will tell you that debt can actually be good for a business. It sounds counter intuitive but there’s a solid case for why taking debt can be beneficial for a business.
The two key reasons supporting this theory are tax benefits and cheaper cost of debt. It is important for people to understand how to reduce tax. In many countries, the government encourages businesses to take debt and to do so provides tax benefits by allowing the interest portions on the debt to be tax-free. With corporate tax rates at 35%, this is quite a saving in your income taxes. This deduction in taxes also reduces the company’s cost of debt, which can become as low as 5%. Equity on the other hand is expensive. Equity investors demand more return on their investment to compensate them for the higher risk taken by them.
With these reasons, it makes sense that financing the business without any debt is not a very intelligent decision. It is actually better to take on debt, which will leverage the returns on the equity investments also.
One may ask: if debt is so cheap then why not finance 100% business through debt? This again will not work because if there is too much debt and very little or no equity, then it become too risky for the financiers to provide financing, which will increase the cost of funding.
Most companies will constantly try to create a balance between equity and debt funding in such a way that their total cost of debt remains low. This is called weighted average cost of capital. After all financing of a business is its very lifeline that needs to be monitored closely and continuously.
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