- Date : 01/05/2022
- Read: 3 mins
Companies depend on two forms of capital, namely, equity and debt. These forms of capital bring in the money required to keep a business running and afloat. However, there is a difference between the two.
They have their own benefits and shortcomings. Let's take a look!
What is Debt Capital?
Debt capital is the capital that companies require to pay back at a later period. It is a form of loan which companies take to raise funding. Such a loan may be short-term or long term like overdraft protection.
The owner's interest is not diluted in a company when opting for debt capital. Still, it can be a little cumbersome to repay the interest until the principal amount is paid off. It is especially true if there is a variable interest rate and it keeps rising.
Companies are legally bound to repay the interest collected on debt capital before issuing any dividends. Annual returns come later for a company, and debt capital is a higher priority.
A much larger sum is generated when companies leverage small amounts. Lenders usually ask for interest payments. The cost of capital debt is the interest rate. Debt capital might require capital for businesses as they require collateral.
To put it into perspective, if a company takes a loan of Rs. 1,00,000 with a 10% interest rate, then the cost of capital is 10% for the loan. Debt payments are tax-deductible in nature, and businesses take into account the corporate taxes when calculating a debt capital's real cost. It is done by multiplying the inverse corporate tax rate and interest rate.
What is Equity Capital?
Equity capital cost is a bit more different from debt capital. Equity capital is the funds that the shareholders invest. Under equity capital, there is no requirement to apply for a loan, which means that there is no repayment. In other words, there is no need to take debt for an equity fund. However, shareholders expect some return on their investments based on the market's performance and the volatility of the stock.
Companies should be able to get returns, healthy valuations, and dividends. These levels shall be equal to or more than the shareholders' investment. Capital Asset Pricing Model (CAPM) uses the risk-free rate, beta value, and the risk of the premium wider market to calculate the cost of equity or expected rate of return.
Generally, the equity cost is more than that of debt cost. Shareholders carry a greater risk than lenders because loan repayment is legally required even if the profit margin is on the lower side.
The following are the forms of equity capital:
- Preferred Stock: This stock option gives shareholders ownership in the company but no voting rights.
- Common Stock: Common stock is sold to shareholders in order to collect money. These shareholders have some voting rights.
- Retained earnings: Retained earnings are the money that has been accumulated by the company over a long period and has not been distributed as dividends.