When a business needs capital to fund its operations and expansion, it makes a choice between these two types of securities:
- Equity
- Debt
Primary difference between the two:
| Equity Capital | Debt Capital |
| Equity capital is available for the company to use as long as it is needed | Debt capital will have
to be returned after the specified time |
| Equity investors are owners of the business | Debt investors are lenders to the
business |
| Equity investors do not enjoy any fixed return or returnof principal invested | Debt investors earn a fixed rate of interest and return of principal at
Maturity |
| Equity investors participate in the management of the business | debt investors do not participate in the management of the business |
| Principal amount invested may grow (Capital appreciation) | Interest is earned by Principal amount remains the same. |
| Dividends maybe declared. | Interest has to be paid. |
Due to the above fundamental differences, investors always tries to make a conscious decision on which side does he want to be on – Debt investor or equity investor.
Equity represents a risky, long-term,growth oriented investment that can show a high volatility in performance, depending on howthe underlying business is performing. There is no assurance of return to the equity investor,since the value of the investment is bound to fluctuate.
Debt represents a relatively lower risk, steady, short-term, income-oriented investment. It generates a steady rate of return, providedthe business remains profitable and does not default on its payments.
Since all residual benefitsof deploying capital in a profitable business go to the equity investor, the return to equityinvestor is likely to be higher than that of the debt investor.
Choosing between equity and debt is a trade-off.
Depending on what the investor wants – participation in higher returns – with an element of risk. Or assured returns, even if lower rate of return. Depending on their risk appetite, they will select from Equity or debt. This process of distributing ones investments between the two is called –Asset allocation.