When it comes to financing a business, there are two main options: debt and equity. Debt financing involves obtaining a loan from a traditional lender, such as a bank, while equity financing involves raising capital in exchange for a percentage of the company's ownership. Both have their advantages and disadvantages, and the optimal capital structure is one that minimizes the weighted average cost of capital (WACC) by adopting a combination of debt and equity. Debt financing is often the preferred option for businesses that want capital with no outside participation. This is because the cost of debt is usually lower than the cost of capital, as interest rates are fixed and bondholders are paid even if there are losses in a given year.
However, incurring excessive debt can cause the cost of debt to exceed the cost of capital, as the risk premium of shares will increase to compensate shareholders for the additional risk. On the other hand, equity financing is often preferred by early-stage companies or those that don't have problems with debt and have a strong credit rating. This is because dividends are declared only if there are profits in that year, and shareholders can participate in business operations. However, if your company sells for millions of dollars, the amount you pay to shareholders could be much higher than if you had kept that property and simply paid back a loan. The debt-to-equity ratio shows how much of a company's funding comes proportionately from debt and equity. To minimize WACC, the capital structure must consist of a balanced combination of both.
ABC Company decides to do so through a combination of equity financing and debt financing. In conclusion, when it comes to financing your business, it's important to consider both debt and equity options. The optimal capital structure is one that minimizes the weighted average cost of capital (WACC) by adopting a combination of debt and equity. While debt financing may be preferable for businesses that want capital with no outside participation, equity financing may be preferable for early-stage companies or those that don't have problems with debt and have a strong credit rating.
