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Finance Mock Interview

Question 6 of 32 for our Finance Mock Interview

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Question 6 of 32

When should a company consider issuing debt instead of equity?

Businesses often need external money to maintain their operations and invest in future growth. There are two types of capital that can be raised: debt and equity. Each type has its share of benefits and drawbacks.

Debt financing is capital acquired through the borrowing of funds to be repaid at a later date. Common types of debt are loans and credit. In addition, payments on debt are generally tax-deductible. The downside of debt financing is that lenders require the payment of interest, meaning the total amount repaid exceeds the initial sum. Also, payments on debt must be made regardless of business revenue (during economic slowdowns, slow down in sales, or new companies) this can be dangerous.

Equity financing refers to funds generated by the sale of stock. The main benefit of equity financing is that funds need not be repaid. Shareholders purchase stock with the understanding that they then own a small stake in the business. The business is then beholden to shareholders and must generate consistent profits in order to maintain a healthy stock valuation and pay dividends. Since equity financing is a greater risk to the investor than debt financing is to the lender, the cost of equity is often higher risk than the cost of debt.

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How to Answer: When should a company consider issuing debt instead of equity?

Advice and answer examples written specifically for a Finance job interview.

  • 6. When should a company consider issuing debt instead of equity?

      How to Answer

      Businesses often need external money to maintain their operations and invest in future growth. There are two types of capital that can be raised: debt and equity. Each type has its share of benefits and drawbacks.

      Debt financing is capital acquired through the borrowing of funds to be repaid at a later date. Common types of debt are loans and credit. In addition, payments on debt are generally tax-deductible. The downside of debt financing is that lenders require the payment of interest, meaning the total amount repaid exceeds the initial sum. Also, payments on debt must be made regardless of business revenue (during economic slowdowns, slow down in sales, or new companies) this can be dangerous.

      Equity financing refers to funds generated by the sale of stock. The main benefit of equity financing is that funds need not be repaid. Shareholders purchase stock with the understanding that they then own a small stake in the business. The business is then beholden to shareholders and must generate consistent profits in order to maintain a healthy stock valuation and pay dividends. Since equity financing is a greater risk to the investor than debt financing is to the lender, the cost of equity is often higher risk than the cost of debt.

      Written by Bobbi Witt

      Entry Level

      "Debt is preferable for the following reasons:
      1. Debt is less risky and a cheaper source of financing
      2. Debt financing provides a tax shield, meaning payments on debt are generally tax deductible.
      3. It helps the company to maximize the return on invested capital (financial leverage)."

      Written by Bobbi Witt

      Experience

      "Debt is cheaper because it is paid before equity and has collateral backing. Debt ranks ahead of equity on liquidation of the business when comparing the cost of debt to the cost of capital

      There are pros and cons to financing with debt vs equity that business needs to consider. It is not automatically a better to use debt financing simply because it's cheaper. A good answer to the question may highlight the tradeoffs, if there is any followup required."

      Written by Bobbi Witt

      Anonymous Interview Answers with Professional Feedback

      Anonymous Answer

      "Debt is generally cheaper and less risky for the company. Shareholders generally want a certain rate of return to equity which makes it more expensive. The company should issue debt company to maintain enough cash to pay regular interest, which is also tax-deductible, and increase the rate of return. However, to answer this question it is important to consider different scenarios and understand the tradeoffs to get the optimal WACC."

      Marcie's Feedback

      Great answer! You do a good job explaining some of the differences between a company issuing debt or equity. Since the question specifically asks when a company should issue debt instead of equity, you may want to mention a specific instance when this would be preferable for a company.