Sebastian Perrier

In choosing between Debt or Equity financing, a good way to analyze the decision is to use the FRICT model. Not that the financing decision is a separate analysis from the investment decision.

1. FLEXIBILITY: debt reduces flexibility because in the future, if you want to raise more money, maybe your only option will be equity because you are highly leveraged. On the other hand, equity provides you with flexibility.
2. RISK (leverage): compare with the industry the levels of leverage vs their P/E ratio. If companies highly profitable and with high P/E ratio are more leveraged than you, maybe you’re under leveraged. Also see your times interest ratio to see if your level of financial risk (leverage) is appropriate to your industry.
3. INCOME (EPS): more debt provides a tax shield and increases profitability and EPS.
4. CONTROL: in terms of debt, the bank usually puts you restrictions which can limit your control. Equity stakeholders may take control if they have more than 50% of the shares.
5. TIMING: whether to finance with debt or equity is also a matter of timing, for example, if at that point in time interest rates are low or maybe the price of your stock is too low to raise funds, etc.

Deciding how to finance the company assets is a separate decision. The financial decision and the investment decision for example, are different things and should be considered separately.

In what regards to the financing decision, the main thing to consider is whether to finance with debt or with equity. Debt is less expensive but it is more risky while equity is more expensive and less risky.

See in the following example two companies which have the same Income Statement, they are equally profitable, but they are financed in different ways:

-> Download spreadsheet with example.

In Scenario 1: Company 1 is 20% financed by debt while Company 2 is 80% financed by debt. Therefore, although both companies have an EBIT of US$200, Company 1 has a ROE of 11% while Company 2 has a ROE of 30%. Investors in Company 2 will have a higher return on their investment because the interest payment is before tax, thus interest expense provide a tax benefit over Company 1.

However, Scanario 2 shows how Company 2 is more risky. If EBIT decreases to US$60, Company 1 remains profitable while Company 2 will become unprofitable.