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There are different sources from which a firm can raise funds. These sources cannot be considered to be equal. They vary from one to another with respect to purpose served, cost and risk involved. They have different magnitude on effect on managerial control. The period which the fund raised will be available differ from one source to the other. The funds raised from different sources can be used for financing new investment, additional working capital and to maintain the value of working capital especially during the time of inflation.
Debt financing is a method of raising money for working capital or capital expenditure in a form of borrowing from individuals and /or institutional investors. These individuals and institutions become creditor and are promised payment of principal and interest. They have no ownership rights attached to the business and their relationship last, when the last payments are made. Debt capital can be long term or short term source of capital. Examples include; bank loans debentures and trade credit. Bank loans can be short term or long term. The amount that can be borrowed from a bank depends on availability of collateral and ability to pay. Debenture is a written acknowledgement incurred by a company. The lender will give out money and in return they are issued with a certificate, and they are paid in future the amount plus interest. Trade credit is an arrangement between a trading company and their suppliers, to be supplied with good which they pay at a later date.
Equity financing is an act of raising funds by selling some unit of ownership to individuals, group of people or an institutional investor. In return, they become shareholders of the company. Equity capital is a long term source of capital for a business. Examples common and preferred share capital. Common share capital is also referred to ordinary share capital. The common share holders have voting right, and they are paid dividends from the profits earned. They have no fixed charge and their dividends are not mandatory. They form the most permanent source of capital and they are last to be rewarded during liquidation. Preference share capital is raised from preference share holders, who have no voting rights and control to the company. They have fixed dividend, and they are given priority to common shareholders during liquidation. The dividend paid to both common and preference shareholders are not tax deductable.
Though a combination of both equity and debt capital is most appropriate, debt capital is more advantageous. Its cost of acquisition is far much lower than equity capital. For example, a company will only require transaction charge and collateral to raise from a bank. To raise equity capital you require prospectus which are expensive to prepare, advertisement registration fee to capital market authority and other flouting costs. The interest paid to debt sources of capital is tax deductable (Hussein, 1989). This reduces the tax liability of a company. Debt finance does not dilute control of the company. The providers have no right of ownership and decision making process of the company. The charge on debt capital is fixed. It does not change even if there is inflation other company makes very high profits. On the other hand, common stockholders will demand more dividends during the time of boom.
In conclusion, there are two broad sources of business finance; the equity which gives the holders the right of ownership and the debt capital, which is sourced from lenders. These two sources have to be used in the best proportion in the financial structure in order to get the optimum advantage and reduce their costs. Analysis must be done on available sources, their costs, risks and what is to be financed using such sources. The capital structure that appeals shareholders and financiers should be up held. The debt equity ratio should guide financial managers on right proportions to use in the capital structure.