1. Debt & Equity Tradeoffs
So let's have a discussion here about the trade offs between debt and
equity, and we really want to talk about the pros and cons.
So on the equity side, well, there's no maturity date and no capital
repayment that's required, the lender has total ownership and a degree of
control over the business. Equity typically has voting rights and it doesn't
involve any interest payments or mandatory fixed repayments. It provides
overall the maximum operational flexibility for the corporation.
But what we can also say about equity is it that it has
a high implied cost of capital, expects a high rate of return,
both through dividends and capital appreciation, and it has last claim on
the firm's assets in the event of a liquidation.
So what can we say about debt? Well, it has interest payments and
it often has a fixed repayment schedule, it prevents dilution of equity
and has a lower cost than equity, which is usually the reason that
corporations prefer to use debt, and it also has first claim on the
firm's assets in the event of a liquidation.
But what we can also say about debt, it requires covenants and financial
performance metrics that must be met by the organization,
contains restrictions on operational flexibility and sometimes can even
push a company into default or bankruptcy.
2. Let's practice!