Debt vs. equity

Successful companies want to grow by acquisition or by inward investment in long-term projects, poorly performing companies need funds to see them through the hard times and companies holding the status quo need to replace fixed assets. The bottom line is that none of these activities can usually be covered by cash flows from operating activities alone, there is a requirement for a longer-term injection of finance.

These additional funds can be raised either from the issue of additional shares or from borrowing and this crucial decision has wide-ranging implications for the financial statements. You will remember that the interest payments on debt are tax deductible but have the downside that they cannot be avoided, whereas dividend payments are at the discretion of management but as an appropriation of profits to shareholders are not tax deductible.

Ignoring the tax deductible nature of interest the cost of debt is usually lower than the cost of equity because lenders are exposed to less risk than the providers of equity finance. Lenders will be paid in priority to shareholders should the company be wound up, and they often secure their position with charges over the...