Debt vs Equity Essay

This essay has a total of 1333 words and 7 pages.

Debt vs Equity

There are two basic ways of financing for a business: Debt financing and equity financing.
Debt financing is defined as 'borrowing money that is to be repaid over a period of time,
usually with interest" (Financing Basics, 1). The lender does not gain any ownership in
the business that is borrowing. Equity financing is described as "an exchange of money
for a share of business ownership" (Financing Basics, 1). This form of financing allows
the business to obtain funds without having to repay a specific amount of money at any
particular time. There are also a few different instruments that could be defined as
either debt or equity. One such instrument is stock options that an employee can exercise
after so many years with the company. Either using the debt or equity method, or a
combination of the two methods can be used to account for stock options or other
instruments with the similar characteristics.

There are pros and cons to deciding to use either of these methods. First I will discuss
the pros of using the debt or equity methods. One pro of using the debt method is that it
"does not entail 'selling' their equity, but instead works by 'borrowing' against it"
(Financing Using, 1). So the company could account for future stock options by assuming
that employees will cash the option in, and, in the books, it will look as if they simply
have a liability. Another pro with the equity method is that the company is receiving
money, and it does not have to pay the money back. In the end the investing company will
normally make money on the investment, but it will come in the form of dividends and/or
selling the stock back.

There are also a few cons in accounting for these instruments are either debt of equity.
"Excessive debt financing may impair your (the company's) credit rating and your ability
to raise more money in the future (Financing Basics, 1). If a company has too much debt,
it could be considered too risky and unsafe for a creditor to lend money. Also with
excessive debt, a business could have problems with business downturns, credit shortages,
or interest rate increases. "Conversely, too much equity financing can indicate that you
are not making the most productive use of your capital; the capital is not being used
advantageously as leverage for obtaining cash" (Financing Basics, 1). A low amount of
equity shows that the owners are not committed to their own business. They do not want to
make the important decisions that could have a big and lasting effect on their own.

Now I will discuss the pros and cons of the alternative decision, which is a combination
of the debt and equity methods. A positive of this method is that the instrument is split
between debt and equity. The company could just split it up 50/50 between the two
methods. Also if they had too much debt, they could account for the instrument with 20% as
debt and 80% as equity. This would make it look as if they do not have too much debt or
too much equity. This method would be an advantage, if the company were looking to get
more financing in the future.

A negative aspect of this method is how the instrument is split between debt and equity.
An example would be if the company split an instrument 50/50 between the two methods.
This may seem fair when first accounting for it, but what if the split did not represent
the actual split of the instrument. Let's say that it turns out that 90% of the
instrument ends up being equity, and 10% ends up debt. The books would be off by quite a
bit, and creditors my not be happy with the company when they learn of this.

Now that I have discussed pros and cons of each method, I will now explain the instrument
that I will be using as an example. I will be using stock options as the instrument.
Stock options are offered by many businesses to employees that stay with the company for a
specified length of time. It is offered by the company as an attempt to keep the
important employees, and to give the employees a reason to help the company get a bigger
market share. With a stock option, an employee may get 100 shares of stock after they are
with the company for five years. Once the five years is up the employee has the option to
keep the shares and watch them grow, or they can take the cash equivalent of the shares.
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