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Debt Finance Condensed Notes
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Chapter 6 – Debt Finance for Companies SGS 9 – Debt FinanceDebt or Equity Finance: Investor Perspective
Factors Equity Debt
Characteristic Dynamic and risky Certain and secure
Return on investment Dividends provide variable returns Interest provides fixed returns
Dividends are discretionary Interest has to be paid as of contractual right
Capital value may increase or decrease Interest could be less profitable than dividends
Repayment of capital On winding up of the company As agreed in loan agreement or terms of bond
On sale of shares (could be difficult if not listed) (bullet or amortising installments)
Availability of new shareholders is variable On enforcement of security on event of default
On redemption or buyback of own shares On sale of the debt before maturity
Risk Shareholders paid back last Creditors are paid back before shareholders
Priority between shareholders (e.g. preference) Creditors can improve priority by taking security
Creditors may contractually agree to give priority
to some lenders and subordinate others (by
Deed of Priority, Intercreditor Agreement or a
Subordination Agreement)
Creditors may spread the risk by – taking security,
syndicated loans or seeking guarantees
Control May have voting rights of variable holding size No control over company decisions other than,
undertakings and control over secured assets
Restriction on sale Directors have discretion to refuse (MA 26(5)) No restriction
Debt or Equity Finance: Company Perspective
Reasons Equity Debt
Dividend or interest Does not need to be repaid (until wind-up) Contractual obligation to pay interest
No need to service debt No direct claim on future profits
Does not require security Could require security
Does not require immediate cash flow Requires constant cash flow
Does not impact credit rating
Tax More expensive than debt Less expensive than equity
Not a tax-deductible expense A tax-deductible expense
Control or gearing Dilution of existing shareholding Does not dilute existing shareholding
Dilution of future profits Inflates debt-to-equity ratio (high gearing ratio),
May raise issues over control deterring future creditors
Availability and cost May be difficult for small private companies to Depending on economic circumstances, could be
attract new investors difficult to obtain and expensive or cheap
Regulation Procedural restrictions in CA06 Restricted by articles and existing loan agreement
Loans are far less regulated
Red Lion Ltd issues 1,000 ordinary shares for £1 for cash on incorporation and takes out a loan of £750, repayable over 5 years –
Red Lion Limited Balance Sheet as at 31 March 2020
Before loan After loan
ASSETS (cash and cash equivalents) 1,000 1,750
Less LIABILITIES (0) (750)
NET ASSETS 1,000 1,000
SHARE CAPITAL 1,000 1,000
RETAINED EARNINGS 0 0
TOTAL EQUITY 1,000 1,000
The higher the debt-to-equity ratio the more geared (or leveraged) a company
Gearing Ratio = (Long-Term Debt ÷ Total Equity) x 100%
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