Debt vs. Equity – Know the Differences

Equity Capital

Debt Capital

Residual claim on income and assets of the business

Senior claim on income and assets of the business

More expensive

Less expensive

Lowers financial risk

Raises financial risk

High levels justified when business is more risky and earnings more volatile

Higher levels may be acceptable when business is less risky and earnings more predictable

More difficult to raise because equity investments are more risky, are highly illiquid, and usually offer no  guarantee of return

Often easier to obtain because lenders are more prevalent, and receive a lower-risk senior claim on business' income and assets, and often obtain a personal guarantee from the owners

Higher levels lower return on equity (investment)

Higher levels raise return on equity (investment) as long as business earns return that exceeds cost of the debt

Cost of equity not "subsidized" by government (i.e., not a tax-deductible expense)

Cost of debt "subsidized" by government (i.e., interest cost is tax deductible)

Higher equity lowers volatility of earnings

Higher debt increases volatility of earnings

Minority equity investments typically have little or no restriction on how company is managed

Often comes with covenants that restrict how company

is managed

Decreases risk of insolvency

Increases risk of insolvency