Equity vs Debt
Monday, October 12th, 2009Deciding 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.
