3.5 Business Financing

Debt vs. Equity Financing

Businesses raise money through debt financing (borrowing money that must be repaid with interest, like loans or bonds) or equity financing (selling ownership shares in exchange for capital). Debt keeps ownership intact but requires repayment regardless of profit. Equity doesn't require repayment but dilutes ownership and control, sharing future profits with investors.

Sources of Financing

Common sources include bank loans, venture capital (funding from investors in exchange for equity, often in high-growth startups), angel investors, bonds (debt securities issued to raise capital), issuing stock, and retained earnings (reinvesting profits). Small businesses may also use personal savings, family loans, or microloans to get started.

Cost of Capital & Risk

The cost of capital is the expense of obtaining funds, including interest rates on debt and expected returns for equity investors. Lenders and investors assess risk using credit history, business plans, and collateral. Higher risk typically demands higher returns or interest rates, influencing which financing option is most affordable for a business.

Key terms

Debt financing

Raising money by borrowing funds that must be repaid with interest, such as loans or bonds.

Equity financing

Raising money by selling ownership shares in the business to investors.

Venture capital

Funding provided by investors to high-growth startups in exchange for equity ownership.

Retained earnings

Profits a business reinvests into itself rather than distributing to owners or shareholders.

Cost of capital

The total expense of obtaining funds, including loan interest rates and expected returns for equity investors.

Try an AP-style question

Debt financing involves…

1. receiving grants that never need repaying
2. selling ownership shares to investors
3. reinvesting the firm's retained profits
4. borrowing money repaid with interest