ENGINEERING 9                                                        DEBT VS. EQUITY

Corporations can raise funds through:

                        Debt: Selling bonds or borrowing from banks or other entities

                        Equity: Selling stock in their corporation

Cost of Funds:

                        Bonds: Company makes interest payments to bond holder for the term of the bond. Usually a constant amount. Failure to make a payment is called a default and bond then becomes due and payable in its entirety.  The amount of the bond is called the Principal and sometimes may be rolled over or renewed when due.

                        Equity: No interest is paid on equity. Sometimes, dividends are paid. Usually these are a per cent of earnings and are paid quarterly. Management may elect not to pay dividends in any year.

Example:

                        Two companies with equal assets of $100 Million.  Company A raised all its money (assets) by selling equity. Company B raised $50 million through selling equity, and $50 million through selling a bond @ 8% interest per annum.

                        COMPANY A               COMPANY B     

SALES                $40 M                        $40

EXPENSES       ($30 M)                   ($30)

EBITDA             $10 M                        $10 M

INTEREST         0          ($4)

TAXABLE

EARNINGS       $10 M                           $6 M

TAXES @40%  ($4) M                          ($2.4 M)

AFTER TAX

EARNINGS       $6 M     $3.6 M

Total Assets             100M               100M

Return on Assets      6%                     3.6%

Shareholder Equity 100M                 50 M

Return on Equity      6%                     7.2%  

Interest is a taxable deduction; dividends are an after-tax disbursement

Debt creates leverage—using other people’s money. Determine if positive or negative.

Debt is risky-need to always pay interest.  A measure of risk is “interest coverage”.

Equity makes manager vulnerable to shareholder pressures.

Non-profits can borrow, not sell equity.  Managers are vulnerable to pressure from donors.