Example – Debt vs Equity Financing
Kyle Ashcraft, CPA · 2019 CPA Exam Scores · 95 FAR · 98 BEC · 91 REG · 90 AUD
Here's how debt and equity financing actually play out, worked through two example companies raising money the same way.
How does raising money through debt financing work?
Say you own Eco Motorcycles, a manufacturer of eco-friendly motorcycles, and you need $5 million to expand internationally. You decide to raise it entirely through debt: you issue 10-year bonds at 3% interest for $5 million, with your company as the issuer.
Every year for 10 years, Eco Motorcycles pays interest of:
To record it, the company debits bond interest expense for $150,000 and credits cash for $150,000. That payment is due every year regardless of how the company is performing — the terms of the bond are fixed. At the end of the 10 years, Eco Motorcycles repays the full $5 million to the bondholders.
How does raising money through equity financing work?
Now say a second company, Motorcycles to Go, rents out motorcycles by the minute and needs $10 million to buy new motorcycles and become profitable. This time, the company raises the money through equity: it issues new shares of common stock in exchange for cash.
Issuing stock means giving up a slice of ownership in the company. Shareholders will expect the company to become profitable and eventually pay dividends — there's no fixed interest payment and no repayment date, but there's also no guarantee of any return at all.
Why is equity financing generally more expensive than debt?
Two reasons. First, interest on debt is tax-deductible, while dividends paid to shareholders are not — debt gets a tax shield that equity doesn't. Second, equity investors take on more risk: they have no fixed repayment and rank behind bondholders if the company goes bankrupt, so they demand a higher return to compensate.
Same goal, different trade-off. Eco Motorcycles locked in a fixed, tax-deductible cost and must pay it regardless of performance. Motorcycles to Go gave up ownership instead of taking on fixed payments, but at a higher underlying cost of capital.
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Kyle Ashcraft, CPA scored 90 or above on every section of the CPA exam in 2019, including a 98 on BEC. He is the founder and sole instructor of Maxwell CPA Review, a complete CPA review course covering all six sections, where he creates every lecture, textbook and study outline himself.