The Daily Technical #16: Walk me through the balance sheet.

Good morning. Welcome to the 16th edition of The Daily Technical. You’re here for one reason so let’s dive in.

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OVERVIEW OF YESTERDAY’S QUESTION
Why would a company issue equity vs. debt (and vice versa)?

When explaining why a company might choose to issue equity vs. debt (and vice versa), you want to cover the key advantages and disadvantages of both options.

Here’s how you can tackle it effectively:

Start with Flexibility and Control: Point out that equity doesn’t require fixed repayments, offering management more flexibility. On the flip side, issuing debt means less flexibility due to required interest and principal payments.

Ownership and Dilution: Explain that issuing equity dilutes ownership, while debt does not. Debt allows original owners to maintain control, whereas new equity holders will have voting rights and could influence company decisions.

Cost Considerations: Emphasize that equity is generally a higher cost of capital due to the risk premium investors demand. Debt often has a lower cost of capital, especially with tax-deductible interest expenses.

Regulatory Scrutiny: Discuss that equity comes with heightened regulatory and disclosure requirements compared to debt. These regulations can be time-consuming and costly.

Tax Implications: Highlight how interest on debt is tax-deductible, which makes debt a cheaper option in some cases. Equity doesn't provide this tax benefit as dividends to shareholders are not deductible.

Pro Tip: point out that debt can impose additional discipline on management, which can be useful for enforcing careful decision-making.

Common Mistakes

1. A common error is to overlook the higher cost of equity versus debt. Always emphasize the the cost of issuing equity (higher due to risk premiums) versus debt (lower due to tax deductions).

2. Some students forget to mention how issuing equity dilutes ownership, which can significantly impact existing shareholders.

3. Often, the regulatory burdens of issuing equity are not discussed, which is a significant disadvantage (regulatory scrutiny and disclosure obligations).

Key Takeaways / TLDR

• Equity provides flexibility but dilutes ownership and introduces regulatory scrutiny.

• Debt offers tax benefits and fewer regulatory hurdles but imposes strict repayment obligations.

• The decision must be balanced based on the company’s need for flexibility, cost constraints, and ownership control.

TODAY’S QUESTION
Walk me through the balance sheet.

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