 | J. Richard Coe, CFP®, CLU ,founded Coe Financial Services in 1983. Dick has been a Certified Financial PlannerTM practitioner since 1983 and a Chartered Life Underwriter since 1991. He is a Registered Principal with London Pacific Securities, Inc., a Registered Broker/Dealer, member NASD & SIPC and an Investment Advisor Representative of Coe Financial Services and London Pacific Advisors. He is a member of the Wichita Estate Planning Council, the Financial Planning Association, and Rotary Club of Wichita. You may contact Dick at Coe Financial Services at 8100 E. 22nd St. North, Building 1400-2 in Wichita, by by phone at (316) 689-0900 , or by e-mail at jrcoe@CoeFinancialServices.com |
Investments
2003-02-01 15:30:00
Debt or equity?
: I have heard it said that most businesses are financed through either debt or equity. What does that mean? What is best?
ANSWER: It is true that businesses are financed through either debt or equity. Think of debt as an obligation -- somebody owes someone something. Think of equity as ownership.Let's start with a personal example. Anytime you purchase something, you pay for it with your money (equity) or with debt (you owe someone). You can purchase a car for cash or borrow to finance it. When people purchase a home, it is typically a combination of equity financing (down payment) and debt (the mortgage).Conceptually, it is the same with a business. Anytime a business purchases anything, it will either use its own money (equity) or someone else's money (debt or liabilities). The right hand side of the balance sheet shows how a business has been financed. Accounts payable, short term borrowings, and long term debt are examples of liabilities. Instead of borrowing, a small business could raise money by selling an ownership interest (equity) to a willing buyer. Similarly, if a corporation issues (sells) stock, ownership interests are being sold. The business gets cash and the investors get stock, which is evidence of ownership. Small and large businesses are also financed in part through retained earnings, which is another form of equity financing. Specifically, earnings are retained in the business rather than paid out as dividends.As to whether it is better for a business to be financed through debt or equity, it is helpful to remember that most businesses are financed by both. Some businesses will have a choice in whether to get new financing by debt or equity, but many businesses will find choices constrained by financial market realities.We can make some generalizations. Whether we are speaking of debt or equity, both are forms of capital and there is always a cost of capital. For a given business debt will be less expensive than equity, but the business will probably have to have a certain amount of equity before it can get much credit (i.e. finance much through debt).If a company gets into financial trouble, the debt holders come ahead of the stockholders. Since there is always more risk with stocks, the only reason for investors to purchase stocks rather than bonds is the potential for a higher expected return. As of January 31, 2003 an investor could purchase AT&T bonds with yields ranging from 5.5% to 8.6%, depending on the maturity. Alternatively, an investor could purchase AT&T stock. A prudent investor would not purchase AT&T stock unless he expected the return to be higher than the return on their bonds, because there is always more risk with the stock.U.S. tax laws have favored debt, because the interest on the debt is a deductible business expense. By contrast, dividends on stock are not deductible and are taxable to the investor. President Bush has proposed to eliminate the taxation of dividends on stock. If the taxation of dividends is eliminated, corporations will not have as much incentive to rely as heavily on debt financing as they have in the past. On the other hand, corporations will have additional incentive to pay out dividends instead of retaining that cash in the business. To the extent earnings are not retained, the business will need to be financed in a different way. Some have wondered why the Bush administration did not propose a deduction for dividends (similar to the deduction for interest) instead of proposing the elimination of taxes on dividends received. Perhaps the best answer for this is conceptual. Interest expense is a legitimate business expense, a cost of doing business. Dividends, by contrast, are simply a return of what already belongs to the owners (stockholders). Dividends are not a cost of doing business and should not be deductible as a business expense.American business will continue to be financed by a combination of debt and equity, but the mix may change if the Bush proposal becomes law.
