Sources of Finance – Debt, Equity & Hybrid

Amazon.com Inc. reports total assets of USD 321,195 million, total liabilities of USD 227,791 million, and total equity of USD 93,404 million in its balance sheet dated December 31, 2020. Based on the reported numbers, Amazon has a debt-to-equity ratio of 2.44 times. Sounds a bit technical, right? Let me decode it for you.

The total assets of USD 321,195 million are financed by debt of USD 227,791 million and equity of USD 93,404 million. Therefore, the ratio of debt financing to equity financing is 2.44 times, i.e., USD 227,791 million/ USD 93,404. In simple words, for every dollar of equity, Amazon has \$2.44 of debt. Put differently, 70.92% (i.e., USD 93,404 million/ USD 321,195) of Amazon’s assets are financed by debts, and the remaining 29.08% is financed by equity.  By now, you must be wondering what’s meant by financing. Financing, in simple words, means sourcing finance or funds. A company can source its funds from different sources, including

1. Commercial banks
2. Nonbank lenders
3. Owners of the company (common stockholders)
4. Preferred stockholders
5. Suppliers
6. Retained earnings

Have a close look at the list. Note that the above sources represent those individuals and institutions who have claims against the company’s assets, i.e., the company’s liability and equity accounts. We can group the liability accounts and simply call them debt financing. Similarly, we can broadly group the owners’ equity accounts—preferred stockholders, common stockholders, and retained earnings—and call them equity financing.

The mix of the various financing components of debt and equity forms a company’s capital structure. In other words, capital structure refers to the mix in which a company finances itself through some combination of loans, bond issue, preferred stock issue, common stock issue, and retained earnings.

Let’s talk about these component sources in a bit of detail.

• Debt financing: When a company borrows from a bank or issues bonds, we can call it debt financing. A company borrows money from banks by taking out loans, or from individuals or other institutions by issuing corporate bonds to them. Thus, the banks and the bondholders are creditors of the company. Generally, we talk only about a company’s long-term debts when it comes to debt financing.

However, we should include all the company’s liabilities because every liability is a debt for the company. In addition to the bond issue and bank loans, money that the company owes to suppliers also comes under the purview of debt financing. When a supplier allows a company to pay for the invoice at a later date, the company is, in effect, getting a loan from the supplier. The company will eventually have to pay, but in the short term, the company records the transaction as an account payable, a debt for the company for Source of Finance.

• Equity financing: When a company raises funds by issuing common stock or using its retained earnings, we call it equity financing. Unlike debt providers, equity contributors are the owners of the company.

• Hybrid equity financing: A company may issue preferred stocks—a hybrid form of financing. It is a hybrid form of financing because we can treat it as a debt in terms of payment, with the annual dividend at a set rate like coupon payments on a bond and as equity in the sense that the company typically does not repay the principal. Therefore, we can consider it somewhere between debt financing and equity financing and call it a hybrid form of equity financing.

Figure 1 shows the three broad component sources of capital talked about so far.

Now that we have understood different component sources of capital, a logical question that arises is what makes a company go for a specific component source of capital over the others. One of the primary considerations, all things being equal, is cost. Note that each component source has costs associated with it. We can associate a different cost of capital with each financing component—debt, equity, and hybrid equity.

Now, the next logical question that comes is what determines the cost of capital. The answer is the rate of return required by the capital providers on their investments. Debt providers would require a lower rate of return on their investment as the interest payments and repayment of their capital are promised irrespective of the volatility of earnings. On the contrary, equity providers would require a higher return on their investment as they, as the owners, bear all the business risks—whether operational or financial. Keep in mind that the cost of capital for the business is the required rate of return for the capital providers.

Thus, it is no wonder that equity is costlier than debt.  Now, you might ask what determines the debt and equity mix in a company’s capital structure. The answer is the optimal weighted average cost of capital (WACC) of the Source of Finance. The WACC refers to the average of the costs of different financing sources weighted by the portion of the funds. We can think of the Source of Finance WACC as the cost of capital for the company as a whole.

Would you like the WACC for your company to be higher or lower? No brainer. Lower, right. Let’s consider the following information to understand the calculation for WACC.

Source	Book Value	After-tax cost
Debt	$100,000	5%
Preferred stocks	$120,000	8%
Equity	$150,000	12%
	$370,000

We can calculate WACC using the following formula:

WACC = (Cost of Debt x Weight of Debt) + (Cost of Preferred Stocks x Weight of Preferred Stocks) + (Cost of Equity x Weight of Equity)

Note that the cost of each component source is given to us. However, we need to calculate the weight for each of the component sources.

Weight of Debt = Book Value of Debt/Total Book Value of Capital

= \$100,000/\$370,000

= 0.2703 or 27.03%

Weight of Preferred Stocks = Book Value of Preferred Stocks/Total Book Value of Capital

= \$120,000/\$370,000

= 0.3243 or 32.43%

Weight of Equity = Book Value of Equity/Total Book Value of Capital

= \$150,000/\$370,000

= 0.4054 or 40.54%

The table showing computation for WACC is as follows:

Source	Book Value	Weight	After-tax Cost	Weighted Cost
A	B	C	D	E = C × D
Debt	$100,000	27.03%	5%	1.351%
Preferred stocks	$120,000	32.43%	8%	2.595%
Equity	$150,000	40.54%	12%	4.865%
	$370,000	100%		8.811%

Therefore, WACC is 8.811%.