So let's see wherewe left off. We were studying the balancesheet of this Bank A, I think that's what I called it. And we said, OK on the assetsside, had some government bonds, had some AAAcorporate bonds, some commercial mortgages. And then this is the thingthat I really wanted to
highlight, that it also had$4 billion of residential collateralized debtobligations. And I explained little bitabout what those are. And I have several tutorialswhere I explain that in more detail. And how they probably led, ormost definitely led, to the housing bubble. And then we have a little bitof cash on top of that.
On the liability side,the bank just owes a lot of money to people. If this were a commercial bank,kind of your Bank of Americas, or your Chases ofthe world, then one of the liabilities here would have alsobeen the deposits of the people who keep theirmoney at the bank. But we're not goingto assume that. This could be justkind of any bank.
Actually, this could be any typeof financial institution. Frankly, it doesn'thave to be a bank. This could be the balance sheetof a hedge fund, or a private equity firm, or prettymuch any type of financial institution. But anyway, back to wherewe were in the example. We said, and we learned it inthe first tutorial, and we learned it in the balance sheettutorial, that if you take
your assets and you subtractout your liability so you take what you have, you subtractout what you owe, you're left with whatyou're really worth. And that's called your equity. And if you're a publicly tradedcompany, actually you don't have to be publiclytraded, but if you're a corporation, that's called yourshareholders' equity. And what does that meané
Well that means the people whoown a stake in the company, or the shareholders, theyshare this piece. And just to hit the point home,and I think this is an important one because Ifeel like people kind of talk past this. There's two notions, there'syour book value of equity, and that's the value of the equitythat comes out of your balance sheet.
Episode 123 Introduction to Debt and Equity Financing
Welcome to Alanis Business Academy. I'm MattAlanis and this is An Introduction to Debt and Equity Financing. Finance is the function responsible for identifyingthe firm's best sources of funding as well as how best to use those funds. These fundsallow firms to meet payroll obligations, repay longterm loans, pay taxes, and purchase equipmentamong other things. Although many different methods of financing exist, we classify themunder two categories: debt financing and equity financing. To address why firms have two main sourcesof funding we have take a look at the accounting
equation. The basic accounting equation statesthat assets equal liabilities plus owners' equity. This equation remains constant becausefirms look to debt, also known as liabilities, or investor money, also known as owners' equity,to run operations. Now lets discuss some of the characteristicsof debt financing. Debt financing is longterm borrowing provided by nonowners, meaningindividuals or other firms that do not have an ownership stake in the company. Debt financingcommonly takes the form of taking out loans and selling corporate bonds. For informationon bonds select the link above to access the tutorial: How Bonds Work.
Using debt financing provides several benefitsto firms. First, interest payments are tax deductible. Just like the interest on a mortgageloan is tax deductible for homeowners, firms can reduce their taxable income if they payinterest on loans. Although deduction does not entirely offset the interest paymentsit at least lessens the financial impact of raising money through debt financing. Another benefit to debt financing is thatfirm's utilizing this form of financing are not required to publicly disclose of theirplans as a condition of funding. The allows firms to maintain some degree of secrecy sothat competitors are not made away of their
future plans. The last benefit of debt financingthat we'll discuss is that it avoids what is referred to as the dilution of ownership.We'll talk more about the dilution of ownership when we discuss equity financing. Although debt financing certainly has itsadvantages, like all things, there are some negative sides to raising money through debtfinancing. The first disadvantage is that a firm that uses debt financing is committingto making fixed payments, which include interest. This decreases a firm's cash flow. Firms thatrely heavily in debt financing can run into cash flow problems that can jeopardize theirfinancial stability.
The next disadvantage to debt financing isthat loans may come with certain restrictions. These restrictions can include things likecollateral, which require the firm to pledge an asset against the loan. If the firm defaultson payments then the issuer can seize the asset and sell it to recover their investment.Another restriction is a covenant. Covenants are stipulations or terms placed on the loanthat the firm must adhere to as a condition of the loan. Covenants can include restrictionson additional funding as well as restrictions on paying dividends. Now that we have reviewed the different characteristicsof debt financing lets discuss equity financing.
Equity financing involves acquiring fundsfrom owners, who are also known as shareholders. Equity financing commonly involves the issuanceof common stock in public and secondary offerings or the use of retained earnings. For informationon common stock select the link above to access the tutorial: Common and Preferred Stock. A benefit of using equity financing is theflexibility that it provides over debt financing. Equity financing does not come with the samecollateral and covenants that can be imposed with debt financing. Another benefit to equityfinancing also does not increase a firms risk of default like debt financing does. A firmthat utilizes equity financing does not pay