Example – Debt vs Equity Financing

Let’s consider an example to see the pros and cons of debt financing and equity financing. You are the owner of a company called Eco Motorcycles. You manufacture and sell eco-friendly motorcycles and want to begin expanding your operations internationally, but need to raise cash. You need $5 million for international expansion.

Let’s imagine that you decide to raise the $5 million exclusively through debt financing. You’re going to sell bonds to raise the money. You’re going to issue 10-year bonds at 3% interest for $5 million. For bonds, the company issuing the bonds is known as the seller.

Every year for 10 years, our company will pay $150,000 of interest ($5,000,000 X 3%). To record the annual journal entry, the company debits bond interest expense of $150,000 and credits cash of $150,000.The company must pay that interest no matter how poorly the company is performing. The terms of a bond are fixed.

We make these annual interest payments, and then at the end of the bond life, we pay back the $5 million to the bondholders. That’s how it would work if Eco Motorcycles was raising the $5 million exclusively through debt.

Now, let’s say that we have a second company that’s called Motorcycles to Go, and this company rents out motorcycles by the minute. The company needs to purchase new motorcycles to become profitable. The company decides to raise $10 million through equity Financing.

The company will issue new shares to raise the money. In other words, the company issues common stock in exchange for cash. When a company issues stock, it gives out ownership in the company. The shareholder will expect that the company is profitable and pays out dividends. Equity financing is typically more expensive than debt financing because if the company is publicly traded, then it has to adhere to the strict guidelines of the US Securities and Exchange Commission.