Financing With Debt Capital

& Financial Leveraging

Lecture 13
 Financing

What is Financing?
Financing is the process of providing funds for business activities, making purchases or investing.
Financial institutions such as banks are in the business of providing capital to businesses,
consumers, and investors to help them achieve their goals.
Example of Financing:
Provided a company is expected to perform well, you can usually obtain debt financing at a lower
effective cost. For example, if you run a small business and need $40,000 of financing, you can
either take out a $40,000 bank loan at a 10% interest rate, or you can sell a 25% stake in your
business to your neighbor for $40,000.
Finance Example

Financing Example
John Bailey has decided to buy a new boat to take his family out on the lake. The
boat dealer is selling the boat for $2,500. However, Mr. Bailey only has $500 saved
for the boat. Mr. Bailey goes to a finance company and completes an application to
borrow $2,000 so he'll have enough money to purchase the boat
Debt Equity

There are two main sources of capital companies rely on—debt and equity.
Debt
Debt capital refers to borrowed funds that must be repaid at a later date. This is
any form of growth capital a company raises by taking out loans.
Equity Capital
The Equity Capital refers to that portion of the organization’s capital, which is
raised in exchange for the share of ownership in the company. These shares are
called the equity shares.The equity shareholders are the owners of the
company who have significant control over its management. They enjoy the
rewards and bear the risk of ownership. However, their liability is limited to the
amount of their capital contributions. The Equity Capital is also called as the
share capital or equity financing.
Equity funds don't require a business to take out debt which means it doesn't
need to be repaid.
Introduction

• Financial Debt:Debt Financing means when a firm

raises money for working capital or capital expenditures

Introduction
by selling bonds, bills, or notes to individual and/or
institutional investors. In return for lending the money,
the individuals or institutions become creditors and
receive a promise to repay principal and interest on the
debt.
Cost
Of
Debt

How Debt Works?

The most common forms of debt are loans, including mortgages and

Introduction
Cost Of Debt
auto loans, and credit card debt. Under the terms of a loan, the borrower
is required to repay the balance of the loan by a certain date, typically
several years in the future. The terms of the loan also stipulate the
amount of interest that the borrower is required to pay annually,
expressed as a percentage of the loan amount. Interest is used as a way
to ensure that the lender is compensated for taking on the risk of the
loan while also encouraging the borrower to repay the loan quickly in
order to limit his total interest expense.
 Financial
Leverage

What is Financial Leverage?

Financial Leverage
Financial leverage is the use of borrowed money (debt) to finance the purchase

Introduction
of assets with the expectation that the income or capital gain from the new asset
will exceed the cost of borrowing.
Leverage = total company debt/shareholder's equity.
financial leverage = debt
equity

In most cases, the provider of the debt will put a limit on how much risk it is
ready to take and indicate a limit on the extent of the leverage it will allow. In the
case of asset-backed lending, the financial provider uses the assets as collateral
until the borrower repays the loan. In the case of a cash flow loan, the general
creditworthiness of the company is used to back the loan.
 How
It
Works?

Financial Leverage
Cost Of Debt
Introduction
How Financial Leverage Works?
When purchasing assets, three options are available to the company for
obtaining financing: using equity, debt, and leases. Apart from equity, the rest
of the options incur fixed costs that are lower than the income that the
company expects to earn from the asset. In this case, we assume that the
company uses debt to finance the asset acquisition.
Example

Example
Assume that Company X wants to acquire an asset that costs $100,000. The company can
either use equity or debt financing. If the company opts for the first option, it will own
100% of the asset, and there will be no interest payments. If the asset appreciates in value

Financial Leverage

Cost Of Debt
Introduction
by 30%, the asset’s value will increase to $130,000 and the company will earn a profit of
WATER

Example
$30,000. Similarly, if the asset depreciates by 30%, the asset will be valued at $70,000 and

HOW?
the company will incur a loss of $30,000.

Alternatively, the company may go with the second option and finance the asset using
50% common stock and 50% debt. If the asset appreciates by 30%, the asset will be
valued at $130,000. It means that if the company pays back the debt of $50,000, it will
remain with $80,000, which translates into a profit of $30,000. Similarly, if the asset
depreciates by 30%, the asset will be valued at $70,000. It means that after the paying the
debt of $50,000, the company will remain with $20,000 which translates to a loss of
$30,000 ($50,000 – $20,000).