Every business needs capital to operate successfully☂. Capital is the money a business—whether it's a small business or a large corporation—needs and uses to run its✱ day-to-day operations. Capital may be used to make investments, conduct marketing and research, and pay off debt.

There are two main sources of capital companies rely on: debt and equity🅷. Both provide the necessary funding needed to keep a business afloat, but there are major differences between the two. And while both types of financing have their benefits, each als🐬o comes with a cost.

Below, we outlin🅠e debt and equity capital, and how they differ.

Debt Capital

Debt capital is borrowed funds that must be repaid at a later date. Any form of capit💛al a company raises by taking out loans falls under this category. These loans may be long-term or short-term such as overdraft protection.

Debt capital does not dilute the company owner's interest in the firm. But it can be cumbersome to pay back interest until loans are paid off—especially when 澳洲幸运5官方开奖结果体彩网:interest rates are high.

Companies need to pay out interest on debt capital in full before they issue any 澳洲幸运5官方开奖结果体彩网:dividends to shareholders. This makes debt capital🅰 higher on a company's list of priorities than sharing profits with investors.

Cost of Debt Capital

While debt allows a company to leverage a small amount of money into a much greater sum, lenders typically require interest payments in return. This interest rate is the cost of debt capital. Debt capital can also be difficult to obtain or mﷺay require collateral, especially for businesses that are in trouble.

If a company takes out a $100,000 loan with a 7% interest rate, the 澳洲幸运5官方开奖结果体彩网:cost of capital for the loan is 7%. Because payments on debts are often tax-deductible, businesses account for the corporate tax rate when calculating the real cost of debt capital by multiplying the interest rate by the inverse of the corporate tax rate. Assuming the corporate tax rate is 30%, the loan in the above example then has a cost of capital of 0.07 X (1 - 0.3) or 4.9%.

Equity Capital

Equity capital is money free of debt and is raised through retained earnings, which are profits the company has retained over the course of the business' history that have not been paid back to shareholders as dividends, or by selling shares of ownership in the company to investors. Shares can be sold to friends and family, professional investors, via an 澳洲幸运5官方开奖结果体彩网:initial public offering (IPO), or through a 澳洲幸运5官方开奖结果体彩网:rights issue.

Equity is often raised by selling 澳洲幸运5官方开奖结果体彩网:common stock, which are shares that represent ownership and give their owners the right to vote on certain company matters. The other main type of stock is 澳洲幸运5官方开奖结果体彩网:preferred stock, which gives shareholders no voting rights but carries a💜 higher claim to dividends or asset distribution.

Equity capital is reported in the stockholder's equity section of a company's balance sheet. In the case of a sole proprietorship, equity capital is reported in the owner's equity section.

Cost of Equity Capital

Because equity capital typically comes from funds invested by shareholders, the 澳洲幸运5官方开奖结果体彩网:cost of equity capital is slightly more complex. Equity funds don't require a business to take out debt, which means it doesn't need to be repaid. However, there is some degree of 澳洲幸运5官方开奖结果体彩网:return on investment shareholders can reasonably expect based on market performance in g꧃eneral and the volatility of the stock in question.

Companies must be able to produce returns—healthy stock valuations and dividends—that meet or exceed this level to retain shareholder investment. The 澳洲幸运5官方开奖结果体彩网:capital asset pricing model (CAPM) utilizes the risk-free rate, the risk premium of the wider market, and the beta🅰 value of the company's stock to determine the expected rate of return or cost of equity.

Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company's profit margins.

The Bottom Line

Debt and equity capital are the two key ways companies raise money. Debt capital involves borrowing money, whereas equity capital is raised through retained earnings and issuingꦍ stock. Equity capital stands out because it carries no🌊 repayment obligation. However, companies and shareholders generally prefer the debt option as it does not require giving up ownership and often works out cheaper.

The cheapest option depends on the company and the broader economy. Not all loans carry the same cost and not all shares are valued the same. Generally, debt is cheaper than equity because the 🎃interest paid on it is often tax-deductible and lenders usually expect lower returns than investors.