Debt Financing vs. Equity Financing
When companies or organizations require funds, they typically have two main options to raise capital: equity financing and debt financing.
Equity financing involves selling a portion of the company’s ownership shares, while debt financing involves borrowing money.
Within debt financing, bonds and debentures are commonly used. While bonds and debentures share similarities, they also have distinct differences.
This article aims to explain these concepts in simple terms, providing examples along the way.
Equity Financing
Equity financing involves the company diluting its shareholding by selling a portion of its own shares.
For example, if a company has 100 shares, it may decide to sell 10% of those shares to new shareholders in order to raise funds.
The money obtained from selling these shares can then be invested in the business. This approach allows the company to raise capital without taking on debt.
However, it results in the existing shareholders’ ownership being reduced proportionally.
Debt Financing
When a company opts for debt financing, it seeks external funds without diluting its shareholding. This can be done by taking a loan from a bank or by issuing bonds or debentures.
Bonds and Debentures:
Bonds and debentures serve as methods for long-term financing. They involve the company borrowing money and promising fixed-interest payments to the bondholders or debenture holders over a specified period.
Similarities:
Both bonds and debentures offer a fixed interest rate and a predetermined period of repayment. Companies typically provide two options for interest payments: either annually or as a lump sum at the end of the maturity period (e.g., 5 or 7 years).
Differences:
The major difference between bonds and debentures lies in their security. Bonds are always secured, meaning the company pledges collateral as security.
This collateral can be auctioned to repay bondholders if the company fails to make payments.
Debentures can be either secured or unsecured. Unsecured debentures pose a higher risk, which results in the company offering higher interest rates to compensate for the increased risk.
Differences: Priority of Payment:
In the event of liquidation or bankruptcy, bondholders have a higher priority for repayment compared to debenture holders.
Bondholders are treated as secured lenders and are repaid first. If debentures are unsecured, their repayment priority comes after bondholders.
Differences: Convertibility:
Debentures may have the option of convertibility, meaning they can be converted into shares of the company.
This allows debenture holders to become shareholders. In contrast, bonds cannot be converted into shares.
Differences: Issuers:
Bonds are issued by various entities, including financial institutions, government organizations, and private companies.
On the other hand, debentures are typically issued by private companies.
| Bond vs Debentures | Bonds | Debentures |
|---|---|---|
| Similarities | Method for long-term financing | Method for long-term financing |
| Fixed interest payments | Fixed interest payments | |
| Predetermined repayment period | Predetermined repayment period | |
| Options for annual or lump sum | Options for annual or lump sum interest payments | |
| Differences | Bonds are always secured | Debentures can be secured or unsecured |
| Collateral is pledged as security | Riskier unsecured debentures offer higher interest | |
| Bondholders have higher repayment | Bondholders have higher repayment priority | |
| priority in case of liquidation | in case of liquidation | |
| Cannot be converted into shares | Convertible debentures can be converted into shares | |
| Issued by various entities | Primarily issued by private companies |
Conclusion
Understanding the options available for raising funds, such as equity financing, debt financing, bonds, and debentures, is crucial for companies and organizations seeking capital.
Equity financing involves selling shares, while debt financing involves borrowing. Bonds and debentures are two forms of debt financing, with bonds being secured and debentures potentially being unsecured.
Both bonds and debentures offer fixed interest payments, but bondholders have a higher repayment priority in case of liquidation.
Debentures may offer the possibility of conversion into company shares. Different entities issue bonds and debentures, with debentures being commonly issued by private companies.
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