In finance, the term “capital structure” refers to the way a firm finances its assets. Generally speaking, there are two main forms of capital structure: debt financing and equity financing (Cumming 52; Myers, 83). Each type has its own advantages and disadvantages, and an essential task for the successful manager of a firm is to find an optimal capital structure in terms of risk and reward for stockholders. When making decisions that affect capital structure, managers must be aware of the impact capital structure has on the firm’s potential for future success, as well as the advantages and disadvantages of debt versus equity financing. Debt financing can be defined as when a firm raises capital by selling bonds, bills, or notes to individual and/or institutional investors. These individuals or institutions become creditors and in return for their loan, they receive a promise that the principal and interest on the debt will be repaid. Banks are the most popular source for debt financing and bank loans are often of great importance in the startup of new firms (Richards 1). There are many advantages to using debt to finance assets, but there are also some disadvantages. One of the greatest advantages of debt financing is that the owner of the firm maintains ownership and control of the business. When an entrepreneur borrows money from an outside source, he or she is obligated to make payments on time. After these payments are made and the full principal and interest have been paid back, the entrepreneur has no further obligations owed to the outside source. (Richards 1). Another great advantage of debt financing is tax deduction. These deductions are made possible because in most cases, the principal and interest payments on a business loan are classified as business expenses, and can be deducted from your business income taxes (Richards 1). In other words, the government has a percentage of ownership in your business by the tax rate, and the more of those taxes cut, the more profitable the business will become (Richards 1). The extra cash from tax deductions can be used to increase stockholder wealth. One disadvantage of debt financing is the risk it carries. If a business is unable to make the repayments on the loan, it will be forced into bankruptcy. Regardless of the success or failure of the business, payments will always have to be made. The lenders of debt financing will have first priority to be repaid before any equity investors (Richards 1). If repayment fails and the company is forced into bankruptcy then it is likely that the lender will take cash or collateral. Another disadvantage of debt financing is the possibly high interest rates. Even after the discounted rates and deductions have taken place one can still experience high interest rates. Also, ones interest rate will vary based on credit rating, personal credit history, and economical conditions (Richards 1). One may encounter very high interest rates if credit history and economic conditions are unfavorable. Further disadvantages of debt financing include the risk of the negative impact unpaid debt will have on the borrower’s credit rating. Credit scores are important, especially for individual entrepreneurs, because of the effect it has on the opportunity to lend money in the future as well as interest rates on future loans. A high interest rate is a loss of money, so it is important to keep the credit rating low. Another disadvantage of debt financing is the process of using cash as down payment, or forms of collateral. These will be lost if the business goes bankrupt. To make a loan one must put up either cash or collateral. Collateral could be assets such as ones car, home, or other personal property. If a business generates insufficient cash flows by the time the loan payment starts, ones collateral is at stake. Most banks and other lenders will most likely ask for some sort of collateral in case of a default in payments...
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