Debt vs. Equity Tutorial: How to Advise Companies on Financing (2024)

If you have an upcoming case study where you have to analyze a company’s financial statements and recommend Debt or Equity, how should you do it?


All else being equal, companies want the cheapest possible financing. Since Debt is almost always cheaper than Equity, Debt is almost always the answer.

Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders’ expected returns are lower than those of equity investors (shareholders).

The risk and potential returns of Debt are both lower.
But there are also constraints and limitations on Debt – the company might not be able to exceed a certain Debt / EBITDA, or it might have to keep its EBITDA / Interest above a certain level.

So, you have to test these constraints first and see how much Debt a company can raise, or if it has to use Equity or a mix of Debt and Equity.

The Step-by-Step Process

Step 1: Create different operational scenarios for the company – these can be simple, such as lower revenue growth and margins in the Downside case.

Step 2: “Stress test” the company and see if it can meet the required credit stats, ratios, and other requirements in the Downside cases.

Step 3: If not, try alternative Debt structures (e.g., no principal repayments but higher interest rates) and see if they work.

Step 4: If not, consider using Equity for some or all of the company’s financing needs.

Real-Life Example – Central Japan Railway

The company needs to raise ¥1.6 trillion ($16 billion USD) of capital to finance a new railroad line.

Option #1: Additional Equity funding (would represent 43% of its current Market Cap).

Option #2: Term Loans with 10-year maturities, 5% amortization, ~4% interest, 50% cash flow sweep, and maintenance covenants.

Option #3: Subordinated Notes with 10-year maturities, no amortization, ~8% interest rates, no early repayments, and only a Debt Service Coverage Ratio (DSCR) covenant.

We start by evaluating the Term Loans since they’re the cheapest form of financing.

Even in the Base Case, it would be almost impossible for the company to comply with the minimum DSCR covenant, and it looks far worse in the Downside cases

Next, we try the Subordinated Notes instead – the lack of principal repayment will make it easier for the company to comply with the DSCR.

The DSCR numbers are better, but there are still issues in the Downside and Extreme Downside cases.

So, we decide to try some amount of Equity as well. We start with 25% or 50% Equity, which we can simulate by setting the EBITDA multiple for Debt to 1.5x or 1.0x instead.

The DSCR compliance is much better in these scenarios, but we still run into problems in Year 4.

Overall, though, 50% Subordinated Notes / 50% Equity is better if we strongly believe in the Extreme Downside case; 75% / 25% is better if the normal Downside case is more plausible.

Qualitative factors also support our conclusions.

For example, the company has extremely high EBITDA margins, low revenue growth, and stable cash flows due to its near-monopoly in the center of Japan, so it’s an ideal candidate for Debt.

Also, there’s limited downside risk in the next 5-10 years; population decline in Japan is more of a concern over the next several decades.

Debt vs. Equity Tutorial: How to Advise Companies on Financing (2)

About Brian DeChesare

Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.

Debt vs. Equity Tutorial: How to Advise Companies on Financing (2024)


Debt vs. Equity Tutorial: How to Advise Companies on Financing? ›

Since Debt is almost always cheaper than Equity, Debt is almost always the answer. Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders' expected returns are lower than those of equity investors (shareholders). The risk and potential returns of Debt are both lower.

How to tell if a company is financed by debt or equity? ›

Debt financing, typically a business loan or line of credit from a financial institution, requires paying off that loan with interest. With equity financing, a company sells some ownership of the business to a private investor in exchange for the desired capital.

How do companies choose between debt and equity financing? ›

A company would choose debt financing over equity financing if it doesn't want to surrender any part of its company. A company that believes in its financials would not want to miss on the profits they would have to pass to shareholders if they assigned someone else equity.

How do you differentiate between debt and equity as methods of financing? ›

Debt financing refers to taking out a conventional loan through a traditional lender like a bank. Equity financing involves securing capital in exchange for a percentage of ownership in the business. Finding what's right for you will depend on your individual situation.

Which factors should be considered when deciding to finance with debt vs equity? ›

Lenders are more interested in your ability to repay the loan, and they charge a fixed interest rate. When choosing between equity and debt financing, consider factors such as the stage and growth potential of the business, cost of capital, ownership control, risk tolerance, and cash flow predictability.

How to know if assets are financed more by debts or equity? ›

The total debt-to-total assets ratio compares the total amount of liabilities of a company to all of its assets. The ratio is used to measure how leveraged the company is, as higher ratios indicate more debt is used as opposed to equity capital.

How to tell if a company is financed by creditors or stockholders? ›

By looking at the Balance Sheet equation, you can determine how the company has financed its assets. They have two options: by borrowing (liabilities) and by using the shareholders' investment (equity).

How do you differentiate between debt and equity financing when starting a business? ›

Debt financing involves borrowing funds that must be paid back over time, typically with interest—however, the lender has no control over your business operations. Equity financing, on the other hand, involves raising capital by selling shares of your company.

How do you determine a company's debt and equity? ›

What Is the Debt-to-Equity (D/E) Ratio? The debt-to-equity (D/E) ratio is used to evaluate a company's financial leverage and is calculated by dividing a company's total liabilities by its shareholder equity. The D/E ratio is an important metric in corporate finance.

Why do most companies use a mixture of debt and equity financing? ›

Creating a capital structure that includes a mix of equity and debt improves a company's financial strength. Equity is also long-term capital. Equity also does not need to be repaid by the company and shareholders have a longer time horizon to realize a return on their investment.

What is the difference between debt and equity for dummies? ›

Debt is when a company borrows money and has to pay it back. Equity is the company's value, what's left after paying off all debts. It's like what the owners (shareholders) really own.

Which of the following best describes the difference between debt and equity financing? ›

The main difference between debt and equity financing is that equity financing provides extra working capital with no repayment obligation. Debt financing must be repaid, but the company does not have to give up a portion of ownership in order to receive funds.

What are three questions financial managers ask when considering long-term financing? ›

What are three questions financial managers ask when considering long-term financing? What sources of long-term funding (capital) are available, and which will best fit our needs? How much long-term funding will be needed to meet the monthly payroll? What are the organization's long-term goals and objectives?

How should a company choose between debt and equity? ›

It's important to analyze the future numbers and accordingly should select the right option. Ownership: For smooth running of business debt is the better option than equity because if a company is going for private equity that means they are giving away some share of ownership to the investors.

How do you determine an appropriate mix of debt and equity? ›

The optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the weighted average cost of capital (WACC) of a company while maximizing its market value. The lower the cost of capital, the greater the present value of the firm's future cash flows, discounted by the WACC.

What are the two major types of financing are debt and equity? ›

Debt and equity are the two main types of finance available to businesses. Debt finance is money provided by an external lender, such as a bank. Equity finance provides funding in exchange for part ownership of your business, such as selling shares to investors.

How do you know if a fund is debt or equity? ›

Debt Vs Equity Fund
  1. Debt funds offer stable returns with lower risk, while equity funds have the potential for higher returns but higher risk.
  2. Debt funds generate income through interest, while equity funds generate income through dividends and capital gains.
Dec 27, 2023

How do you distinguish between debt and equity financial securities? ›

First, debt market instruments (like bonds) are loans, while equity market instruments (like stocks) are ownership in a company. Second, in returns, debt instruments pay interest to investors, while equities provide dividends or capital gains.

Can you see if a company is in debt? ›

Balance Sheet Test: Determines whether a company's assets are worth less than it's liabilities. You should seek advice to do a balance sheet test. If a company's liabilities are found to exceed its assets then the business would not be able to cover creditor repayment in the event of the business being sold.

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