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Debt vs Equity

There are two basic ways of financing for a business: Debt financing and equity financing. Debt financing is defined as 'borrowing money that is to be repaid over a period of time, usually with interest" (Financing Basics, 1). The lender does not gain any ownership in the business that is borrowing. Equity financing is described as "an exchange of money for a share of business ownership" (Financing Basics, 1). This form of financing allows the business to obtain funds without having to repay a specific amount of money at any particular time. There are also a few different instruments that could be defined as either debt or equity. One such instrument is stock options that an employee can exercise after so many years with the company. Either using the debt or equity method, or a combination of the two methods can be used to account for stock options or other instruments with the similar characteristics.

There are pros and cons to deciding to use either of these methods. First I will discuss the pros of using the debt or equity methods. One pro of using the debt method is that it "does not entail 'selling' their equity, but instead works by 'borrowing' against it" (Financing Using, 1). So the company could account for future stock options by assuming that employees will cash the option in, and, in the books, it will look as if they simply have a liability. Another pro with the equity method is that the company is receiving money, and it does not have to pay the money back. In the end the investing company will normally make money on the investment, but it will come in the form of dividends and/or selling the stock back.

There are also a few cons in accounting for these instruments are either debt of equity. "Excessive debt financing may impair your (the company's) credit rating and your ability to raise more money in the future (Financing Basics, 1). If a company has too much debt, it could be considered too risky ...

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