INTRODUCTION

Companies can raise capital via debt or equity. Equity refers to stock, or an
Ownership stake, in a company’s equity become shareholders recoup their
Investment when the company's value increases (their shares rise in value) or
when the company pays a dividend. Buyers of a company’s debt are lenders;
they recoup their investment in the form of interest paid by the company on
the debt.

Debt market and equity market are broad terms for two categories of
investment that are bought and sold.

Equities are inherently riskier than debt and have a greater potential for big
gains or big losses.

Statement of problem

What is more beneficial to a company- Equity or debentures? Debts financing

refers to taking out a conventional loan through a traditional lender like a
bank. Equity financing involves securing capital in exchange for a percentage
of ownership in the business. Finding what’s right for you will depend on your
individual situation.

Conceptual Review

Equity & debenture

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Equity: The word ‘equity’ has been derived from a Latin word ‘aequus’ which
means to equal and fair.

Debenture: The word ‘debenture’ has been derived from a Latin word ‘debere’
which means to borrow. Company raises its capital by means of issue of
shares. But the funds raised by the issue of shares are seldom adequate to
meet their long term financial needs of a company. Hence, most companies
turn to raising long-term funds also through debentures which are issued
either through the route of private placement or by offering the same to the
public. The finances raised through debentures are also known as long-term
debt. This chapter deals with the accounting treatment of issue and
redemption of debentures and other related aspects.

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 REVIEW OF LITERATURE

Equity and debt are the two sources of finance for firms. Equity is permanent
in the business but costlier, debt is cheaper but excess of debt may lead to
bankruptcy. Equity theory comprises of shareholders theory, propriety theory
and entity theory. Debt theory comprises credit theory of money and
stakeholder theory. The combination of equity and debt theories is embedded
in capital structure theory. Initially, the theories of capital structure included
net income theory, net operating income theory and traditional theory. The
net operating income approach was refined by two scholars in 1958 who,
assuming perfect market conditions, proposed that capital structure was
irrelevant to the market value of firms. Other theories have been formulated
under imperfect market conditions, the two leading ones are trade-off theory
and pecking-order theory. Empirical findings are inconclusive about which of
two theories under imperfect market is more relevant. However, scholars
agree that both equity and debt affect firm financing.

Advantages of Equity

Less risk: You have less risk with equity financing because you don't have any
fixed monthly loan payments to make. This can be particularly helpful with
startup businesses that may not have positive cash flows during the early
months.

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Credit problems: If you have credit problems, equity financing may be the
only choice for funds to finance growth. Even if debt financing is offered, the
interest rate may be too high and the payments too steep to be acceptable.

Cash flow: Equity financing does not take funds out of the business. Debt loan
repayments take funds out of the company's cash flow, reducing the money
needed to finance growth.

Long-term planning: Equity investors do not expect to receive an immediate

return on their investment. They have a long-term view and also face the
possibility of losing their money if the business fails.

Disadvantages of Equity

Cost: Equity investors expect to receive a return on their money. The business
owner must be willing to share some of the company's profit with his equity
partners. The amount of money paid to the partners could be higher than the
interest rates on debt financing.

Loss of Control: The owner has to give up some control of his company when
he takes on additional investors. Equity partners want to have a voice in
making the decisions of the business, especially the big decisions.

Potential for Conflict: All the partners will not always agree when making
decisions. These conflicts can erupt from different visions for the company
and disagreements on management styles. An owner must be willing to deal
with these differences of opinions.

Advantages of Debt

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Control: Taking out a loan is temporary. The relationship ends when the debt
is repaid. The lender does not have any say in how the owner runs his
business.

Taxes: Loan interest is tax deductible, whereas dividends paid to

shareholders are not.

Predictability: Principal and interest payments are stated in advance, so it is

easier to work these into the company's cash flow. Loans can be short,
medium or long term.

Disadvantages of Debt

Qualification: The Company and the owner must have acceptable credit
ratings to qualify.

Fixed payments: Principal and interest payments must be made on specified

dates without fail. Businesses that have unpredictable cash flows might have
difficulties making loan payments. Declines in sales can create serious
problems in meeting loan payment dates.

Cash flow: Taking on too much debt makes the business more likely to have
problems meeting loan payments if cash flow declines. Investors will also see
the company as a higher risk and be reluctant to make additional equity
investments.

Collateral: Lenders will typically demand that certain assets of the company
be held as collateral, and the owner is often required to guarantee the loan
personally.

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When looking for funds to finance the business, an owner has to carefully
consider the advantages and disadvantages of taking out loans or seeking
additional investors. The decision involves weighing and prioritizing
numerous factors to decide which method will be most beneficial in the long-
term.

The choice between equity and debentures depends on the specific needs and
goals of the company. A company can choose to raise money either via equity
or debt. Both have their advantages and disadvantages. In the end, it really
depends on the company and its capital structure.

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 OBJECTIVES OF THE STUDY

• To evaluate and compare the performance of equity & debt.

• To compare the risk assessments of debt & equity.

• To find out which sources of finance is better.

• Which long term sources are more beneficial for business?

• To discuss equity and debt theories.

• To relate the theories with agency theory.

• To examine the interplay of the theories above in corporate capital.

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 RESEARCH METHODOLOGY

Cost of Equity

A company’s cost of equity represents the average, annualized, nominal

total return expected by shareholders. For most companies, COE is the
dominant factor in the company's WACC and therefore holds sizable
influence in the valuation process. However, in contrast to fixed-rate forms
of capital, the COE is not a contractual return. It cannot be observed
directly, and considerable controversy persists in theoretical finance as to
how the COE is best estimated. Morningstar’s process for estimating COE is
inspired and informed by the logic of the capital asset pricing model
(CAPM) even as we take a largely qualitative and forward-looking
approach. Our goal is to provide reasonable distinctions between the risk
characteristics and expected returns of different companies while
minimizing the effects of regency bias, false precision, and market noise.
We use a building block approach to derive COE estimates for individual
companies:

Cost of Equity = Market Average Real Return Expectation

(6.5%–7.0% based on what we observe as a mean-reverting

Real return of the S&P 500 over long rolling time horizons—

This is not a forecast, but rather what we believe shapes

Investor expectations)

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+ Inflation Expectation (2.0%–2.5% based principally on stable

10- to 30-year inflation expectations derived from TIPS spreads

As well as actual CPI over the last decade)

+/, Country Risk Premium (for non-USD reporting firms; this

Will reflect differentials in inflation and real risk-free rate

Expectations outside the U.S. as well as political risks)

+/ , Systematic Risk Premium (four categories; ranges from

-1.5% to +4.5%)

Exhibit Systematic Risk Premium Categories

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Importantly, because the fair value estimate reflects the present value of
expected future cash flows, it should rise by the company’s estimated cost
of equity (net of the shareholder return allocated to dividends) over time,
all else equal.

Cost of Debt

In estimating the cost of debt, we use a similar building-block approach as

our cost of equity. We use the same assumed risk-free rate and level of
inflation, while layering on a corporate credit spread, which varies
according to the company’s credit risk. We also adjust for the tax benefit of
the deductibility of interest expenses.

Once we have these inputs, we weight them in terms of the implied value of
each as a proportion of total estimated enterprise value to come up with
our overall WACC estimate.

A significant percentage of our coverage includes firms domiciled outside

the United States, and there are those that call the U.S. home but have
considerable non-U.S. operations. Depending on the systematic risk of a
country relative to the U.S., we may incorporate a country risk premium
into our discount rate. Some characteristics that we consider are
differences in local real risk-free rate, expected

Inflation, financial disclosure, and other specific operating-market

Differences that could cause equivalent businesses to be more or less risky

in one national economy versus another. In assigning country risk preemie,
we have developed a set of country-specific standardized scores that are
reviewed at least once annually.
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Hidden Assets/Liabilities

Once we have an estimated present value of expected future cash flows, we

must also consider any other items that affect value not specifically
included within our cash-flow projections. We refer to these special items
as hidden assets and hidden liabilities, and they might include items that
occur frequently across our coverage universe, such as the estimated value
of outstanding option grants or

underfunded/overfunded pensions, or items that tend to be very company-

specific in nature, such as minority ownership positions in other
companies, underutilized land or other balance sheet assets that could be
sold without changing the cash-flow prospects of the business, or an
expected future litigation settlement. It is impractical to list all the possible
hidden assets and liabilities we find across our

Coverage, but we think about these hidden assets and liabilities as anything
that affects value that is handled outside of our cash-flow

Forecast.

The Uncertainty Rating

Morningstar’s Uncertainty Rating is designed to capture the range of

potential outcomes for a company’s intrinsic value. This rating is used to
assign the margin of safety required before investing,

This in turn explicitly drives our stock star rating system. The Uncertainty
Rating is aimed at identifying the confidence we should have in assigning a
fair value estimate for a given stock.

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Our Uncertainty Rating is meant to take into account anything that can
increase the potential dispersion of future outcomes for the intrinsic value
of a company, and anything that can affect our ability to accurately predict
these outcomes. The rating begins with a suggested rating produced by a
quantitative process based on the trailing 12-month standard deviation of
daily stock returns. An analyst overlay is then applied, with analysts using
the suggested rating, historical rating data, and their own knowledge of the
company to inform them as they make the final Uncertainty Rating
decision. Ultimately, the rating decision rests with the analyst. Analysts
take into account many characteristics when making their final decision,
including cyclical factors, operational and financial factors such as leverage,
company-specific events, ESG risks, and anything else that might increase
the potential dispersion of future outcomes and our ability to estimate
those outcomes.

Our recommended margin of safety—the discount to fair value demanded

before we’d recommend buying or selling the stock—widens as our
uncertainty of the estimated value of the equity increases. The more
uncertain we are about the potential dispersion of outcomes, the greater
the discount we require relative to our estimate of the value of the firm
before we would recommend the purchase of the shares. In addition, the
Uncertainty Rating provides guidance in portfolio construction based on
risk tolerance.

Our Uncertainty Ratings are: Low, Medium, High, Very High, and Extreme.
With each uncertainty rating is a corresponding set of price/fair value
ratios that we use to assign star ratings, as shown in the graph.

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The actual price/fair value cutoffs are determined using a combination of
a) empirical data from the historical performance of our uncertainty rating,
and b) option pricing theory based on the implied volatility of stocks with
commonly agreed-upon uncertainty characteristics. Our empirical data
show that appropriate 1-star and 5-star prices fall approximately at the
midpoint between a log-normal relationship and a symmetrical
relationship. A log-normal relationship would mean that a stock would
post the same return between the 5-star price and the fair value as it would
between the fair value and the 1-star price, while a symmetrical
relationship would mean that the same percentage discount to a stock
price for a 5-star rating would be assigned as a premium to the stock price
for a 1-star rating. For low-, medium-, high-, and very-high-uncertainty
stocks we formally assign our 1-star prices as the midpoint between the
symmetrical and the log-normal relationship. We then round these prices
to fair value relationships to the nearest 5 percentage points for simplicity.
For extreme uncertainty stocks we assign the 1-star price using the log-
normal relationship only. Typically, a significant portion of an extreme
uncertainty company’s capital structure is composed of debt. Using the
lognormal relationship to set the 1-star price accounts for the fact that a
small improvement in the forecast for free cash flows will have an outsize
upside impact to the equity value for any highly-indebted company.

Exhibit Morningstar Equity Research Star Rating Methodology

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Generating the Star Rating

Once we determine the fair value estimate of a stock, we compare it with

the stock’s current market price on a daily basis, and the star rating is
automatically re-calculated at the market close on every day

The market is open.

Our analysts keep close tabs on the companies they follow, and, based on
thorough and ongoing analysis, raise or lower their fair value estimates as
warranted. Furthermore, as mentioned earlier, we would expect our fair
value estimates to generally rise over time,

due to the time value of money. Specifically, over the course of a year,
barring major changes to analyst assumptions, we would expect our fair
value estimates to increase at the level of our estimate of a firm’s cost of
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equity (net of shareholder returns attributed to dividends). So, for a stock
that pays no dividends with a $100 fair value estimate today and an
estimated 10% cost of equity, we would expect our fair value estimate to
rise to $110 in 12 months, all else equal. It is also worth noting that there is
no predefined distribution of stars. That is, the percentage of stocks that
earn 5 stars can fluctuate daily, so the star ratings, in the aggregate, can
serve as a gauge of the broader market’s valuation. When there are many
5-star stocks, the stock market as a whole is more undervalued, in our
opinion, than when very few companies garner our highest rating.

We expect that if our base-case assumptions are true the market price will
converge on our fair value estimate over time, generally within three years
(although it is impossible to predict the exact time

Frame in which market prices may adjust). If you bought a company’s stock
at exactly our fair value estimate today, we would expect that you should
achieve total returns in line with our assumed cost of equity for the next
three years, absent a change in business prospects relative to our base-case
expectations. A stock price lower than our fair value estimate suggests that
there is a higher probability than not that investors should expect returns
at a greater rate than COE over a three-year period (i.e., we would expect
the investment to produce abnormal returns or alpha). Conversely, a price
above our fair value estimate implies lower-than-COE expected returns (or
negative alpha). In some cases, we believe investors should expect negative
absolute returns, if the price/fair value estimate ratio is sufficiently high.

Our star ratings are guideposts to a broad audience and individuals

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Must consider their own specific investment goals, risk tolerance, tax
situation, time horizon, income needs, and complete investment portfolio,
among other factors.

We believe appreciation beyond a fair risk-adjusted return is highly likely

over a multiyear time frame. Scenario analysis developed by our analysts
indicates that the current market price represents an excessively
pessimistic outlook, limiting downside risk and maximizing upside
potential This rating encourages investors to consider an overweight
position in the security relative to the appropriate benchmark.

Appreciation beyond a fair risk-adjusted return is likely, in our opinion.

This rating encourages investors to own the firm’s shares, possibly
overweight relative to the appropriate benchmark after fully considering
more attractively priced alternatives, such as our 5-star recommendations.

Indicates that we believe investors are likely to receive a fair risk-adjusted

return (approximately cost of equity). Concentrated portfolios might
consider exiting these positions if more attractively priced alternatives are
available.

We believe investors are likely to receive a less than fair risk-adjusted

return and should consider directing their capital elsewhere. Securities
with this recommendation should generally be underweight, assuming less
expensive alternatives are available for the portfolio strategy being
employed.

Indicates a high probability of undesirable risk-adjusted returns from the

current market price over a multiyear time frame, based on our analysis.

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Scenario analysis by our analysts indicates that the market is pricing in an
excessively optimistic outlook, limiting upside potential and leaving the
investor exposed to Capital loss.

Capital Allocation

While not directly impacting our Star Rating, our Capital Allocation (or
Stewardship) Rating represents our assessment of the quality of
management’s capital allocation, with particular emphasis on the firm’s
balance sheet, investments, and shareholder distributions. Analysts
consider companies’ investment strategy and execution, balance sheet
management, as well as dividend and share buyback policies. Corporate
governance factors are only considered if they are likely to materially
impact shareholder value, through the balance sheet, investment, or
shareholder distributions. Analysts assign one of three ratings:
"Exemplary", "Standard", or "Poor". Analysts judge Capital Allocation from
an equity holder’s perspective. Ratings are determined on a forward
looking and absolute basis. The Standard rating is most common as most
managers will exhibit neither exceptionally strong nor poor capital
allocation. For a company's balance sheet, we consider the current position
and how it is likely to evolve, whether a firm has reasonable or excessive
leverage, and if a company will generate sufficient cash flow to make
meaningful improvement if necessary. For investment, we consider if a
firm is likely to invest to fortify or enhance its competitive position in
future, and if it is likely to do so at the right price - that is, generating
attractive rates of return above the estimated cost of capital. We also
consider execution and if material

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missteps or successes are likely. For shareholder distributions, we consider
if future dividends and/or share buybacks are likely of the appropriate size
and form. Cash should be distributed to shareholders unless better uses
exist and the opportunity cost of foregoing investment or strengthening the
balance sheet is considered. Capital Allocation (or Stewardship) analysis
published prior to Dec. 9, 2020, was determined using a different process.
Beyond investment strategy, financial leverage, and dividend and share
buyback policies, analysts also considered execution, compensation,
related party transactions, and accounting practices in the rating.

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 DATA ANALYSIS & INTERPRETATION

If you have followed the TV show Shark tank, then you are familiar with the
haggling process after the business owner's pitch, in which investors offer
(and adjust their offers) for upfront capital in exchange for equity (check
out a sample deal negotiation with inflatable pad manufacturer, wined
archer), while the wind catcher owner was lucky enough to receive a with a
lower equity stake than he was willing to give up, he still has to part ways
with 5% ownership in his company. When seeking equity financing other
business owners may not be as lucky and have to give up a 10%, 15% or
even 20% stake of their company for an investor to be willing to fork out
cash.

With debt financing you don't have to give out a stake in your company.
Under certain circumstances, you may have to use a piece of machinery,
vehicle, or very liquid accounts receivable as a collateral for a loan, but you
only would have to give up ownership of that collateral if you were to
default on the loan, ownership of your company stays with you.

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Which type of financing is best for your business?

Choose Equity financing if..........

• You picture your business growing to a global or national scale.

• You have larger capital needs that wouldn't be satisfied through debt
financing.

• You're willing to give up some control over your business in

exchange for equity.

• You're looking for more than just money, i.e. industry connections
and experience.

• You're willing to put in the work to pitch to investors.

• Your capital needs aren't urgent.

Choose debt financing if.......

• You have smaller capital needs.

• You need capital but don't want to give up ownership interest in your
business.

• You're willing to take on risk, including losing assets if you fail to

repay your lender.

• You need financing quickly.

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 FINDINGS AND RECOMMEDATIONS

Findings- Finding one or more people willing to invest in your business

can be a difficult and time-consuming process. If you need money quickly
or with little effort, equity financing is likely not right option for you.

There are very clear differences between debt and equity financing with
debt financing, you simply have to meet the criteria of a lender in order to
receive money. Depending on the type of financing you seek, you could
have the capital you need in as little as 24 hours. In exchange for this
capital, you pay the lender back as agreed. You take on all the risk, so if
your business fails, you may lose your assets or face legal action.

Additionally, with debt financing, you don't have to worry about drawing
up legal paperwork, apply for your loan, submit the required information
and documentation, and the lender will provide you with money if you
qualify. You retain full ownership of your business.

On the flip side, equity financing could take some time. It is up to you find
the right investors willing to work with your business. Drawing up legal
paperwork will be part of the process as well.

While you don't have to pay your investor back over the short-term, the
lender will recoup their money if your business is successful, because they
will own part of the company, they will be able to take their share of the
profits and make important decisions about your business along the way.

27
The risk is on the lender. If your business is successful, the lender gets their
capital plus a return. If your business is unsuccessful, you will not be
indebted as you would with debt financing.

Recommendations- There are many ways to get capital for your

business through debt financing or equity financing. However, it's very
important that you weigh out the pros and cons and consider the specific
needs of your business before moving forward. While your capital needs
may be urgent, it's critical to look at the long-term picture to determine
what type of financing will most benefit your business.

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 CONCLUSION

Whether business takes debt or equity financing depends upon the need
and requirement of the business. Debt and equity both are solutions that
can solve the find related problems of the business. Both debt and equity
have their advantages and disadvantages. It is up to the owner to select
which suits the business needs.

It is not possible to recommend an ideal source of finance for any project.

What is important is that students appreciate the advantages and
disadvantages of different financing methods and can provide reasoned
advice to businesses.

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 REFERENCES

https://www.investopedia.com/ask/answers/042215/what-are-
benefits-company-using-equity-financing-vs-debt-
financing.asp#:~:text=Debt%20financing%20involves%20the
%20borrowing,the%20money%20acquired%20through%20it.

https://corporatefinanceinstitute.com/resources/commercial-
lending/debt-vs-equity/

https://aofund.org/resource/debt-vs-equity-financing/

https://www.investopedia.com/financial-edge/1112/small-business-
financing-debt-or-equity.aspx

https://www.business.com/articles/debt-vs-equity-financing/

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