Debt finance includes both secured loans and unsecured loans. Security involves a form of collateral as an assurance the loan will be repaid.
Debt financing occurs when a firm raises money for working capital or capital expenditures by selling debt instruments to individuals and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid.
When a company needs money, it can take three routes to obtain financing: equity, debt, or some hybrid of the two. Equity represents an ownership stake in the company. It gives the shareholder a claim on future earnings, but it does not need to be paid back. If the company goes bankrupt, equity holders are the last in line to receive money. The other route a company can take to raise capital for its business is by issuing debt – a process known as debt financing.
Debt financing occurs when a firm sells fixed income products, such as bonds, bills, or notes, to investors to obtain the capital needed to grow and expand its operations. When a company issues a bond, the investors that purchase the bond are lenders who are either retail or institutional investors that provide the company with debt financing. The amount of the investment loan, referred to as the principal, must be paid back at some agreed date in the future. If the company goes bankrupt, lenders have a higher claim on any liquidated assets than shareholders.
Cost of Debt Financing
A firm’s capital structure is made up of equity and debt. The cost of equity is the dividend payments to shareholders, and the cost of debt is the interest payment to bondholders. When a company issues debt, not only does it promise to repay the principal amount, it also promises to compensate its bondholders by making interest payments, known as coupon payments, to them annually. The interest rate paid on these debt instruments represent the cost of borrowing to the issuer.
The sum of the cost of equity financing and debt financing is a company’s cost of capital. The cost of capital represents the minimum return that a company must earn on ts capital to satisfy its shareholders, creditors, and other providers of capital. A company’s investment decisions relating to new projects and operations should always generate returns greater than the cost of capital. If returns on its capital expenditures are below its cost of capital, then the firm is not generating positive earnings for its investors. In this case, the company may need to re-evaluate and re-balance its capital structure.
If the debtor defaults on the loan, that collateral is forfeited to satisfy payment of the debt. Most lenders will ask for some sort of security on a loan. Few, if any, will lend you money based on your name or idea alone. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid.
A debt is an obligation owed by one party (the debtor) to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value. A debt is created when a creditor agrees to lend a sum of assets to a debtor. Debt is usually granted with expected repayment; in modern society, in most cases, this includes repayment of the original sum, plus interest.
Debt finance is a means of using anticipated future purchasing power in the present before it has actually been earned. Some companies and corporations use debt as a part of their overall corporate finance strategy.
The most common source of debt finance for startups often isn’t a commercial lending institution, but family and friends. When borrowing money from your relatives or friends, have your attorney draw up legal papers dictating the terms of the loan. Why? Because too many entrepreneurs borrow money from family and friends on an informal basis. The terms of the loan have been verbalized but not written down in a contract.
Debt finance can be long-term or short-term. Long-term debt financing usually involves a business’ need to buy the basic necessities, such as facilities and major assets, while short-term debt financing includes debt securities with shorter redemption periods and is used to provide necessities such as inventory and/or payroll.
Tax deductions are huge attraction for debt financing. In most cases, the principal and interest payments on a business loan are classified as business expenses, and thus can be deducted from your business income taxes. It helps to think of the government as a “partner” in your business, with a 30% ownership stake (or whatever your business tax rate is). If you can cut the government out of the equation, then it’s beneficial to your business.
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