Question

Why do companies choose to raise capital by borrowing versus issuing stock?Is borrowing more expensive than issuing stock or less expensive?

Answer 1

Borrowing is less expensive than issuing stock.

let's take an example to understand this.

suppose you want to start a small business and you need $50,000. All you can invest is $30,000. now, there are two options, either you go to bank and borrow $20,000 @ 10% interest p.a. or you go to an investor that can be your friend, relative or who so ever, and ask to invest in your business at the stake of 40% for $ 20,000.

Now, Assuming business is doing well and you earned profit of $ 25,000. now,

• if you have taken a bank loan, than your only expense is interest on loan i.e. $20,000 * 10% = $ 2,000.

Your net profit is $25,000-$2,000= $23,000.

• if you finance through investor than share of stakeholder will be 40% in your Profit i.e. $10,000.

your net profit is $25,000-$10,000 = $15,000.

hope you got your answer.