2.4: Debt and Equity

Learning Objectives

1. Define equity and debt.
2. Compare and contrast the benefits and costs of debt and equity.
3. Illustrate the uses of debt and equity.
4. Analyze the costs of debt and equity.

Buying capital, that is, borrowing, enables you to invest without first owning capital. By using other people’s money to finance the investment, you get to use an asset before owning it free and clear, assuming you can repay it out of future earnings. Buying capital gives you equity, borrowing capital gives you debt, and both kinds of financing have costs and benefits. When you buy or borrow liquidity or cash, you become a buyer in the capital market.

The Costs of Debt and Equity

You can buy capital from other investors in exchange for an ownership share or equity, which represents your claim on any future gains or income. If the asset is productive, it will store wealth, generate income, or reduce expenses. The equity holder, shareholder, or owner enjoys benefits in proportion to their share of the asset. If the asset loses value, the owner bears a portion of the loss in proportion to their share of the asset. The cost of equity occurs when you share the benefits from the investment.

Borrowing is essentially renting someone else’s money for a specified period, resulting in debt. During that period, rent or interest must be paid, which is a cost of debt. When that period expires, all the capital (the principal amount borrowed) must be paid back. The investment’s earnings must be enough to cover the interest, and its growth in value must be enough to return the principal. Thus, debt is a liability, an obligation for which the borrower is liable.

In contrast, the cost of equity may need to be paid only if income or wealth increases, and even then, it can be deferred. From the buyer’s point of view, purchasing liquidity through borrowing (debt) has a more immediate impact on income and expenses. Interest must be added as an expense, and repayment must be anticipated.

Table 2.4.1 shows the implications of equity and debt as the sources of capital.

Table 2.4.1 : Sources of Capital

	Equity	Debt
Trade	Buy Capital	Borrow Capital
Cost/Expense	Share Profits and Gains	Pay Interest
Market	Capital Market	Credit Market

The Uses of Debt and Equity

Debt is a means of making an investment that would otherwise be unattainable. You incur debt when you buy an asset (e.g., a house, a car, or corporate stock) that you couldn’t buy without borrowing. If that asset is expected to provide sufficient benefit (i.e., increase value, generate income, or reduce expenses) to compensate for its additional costs, then the debt is worthwhile. However, if debt creates additional expense without enough additional benefit, then it is not worth it. The problem is that costs are usually known up front, but benefits are not. That adds a dimension of risk to debt, which is another factor in assessing whether it’s desirable.

Debt may also be used to cover a budget deficit, or the excess of expenses over income. However, in the long run, the cost of the debt will increase expenses that are already too big, which is what created the deficit in the first place. Unless income can also be increased, debt can only aggravate a deficit.

The Value of Debt

The value of debt includes the benefits of acquiring the asset sooner rather than later, which debt financing enables. One example of the value of debt is using debt to finance an education. Education is valuable because it offers numerous benefits that can be enjoyed throughout a lifetime. One benefit is an increase in potential earnings in wages and salaries. The demand for educated or more skilled employees is generally greater than for uneducated or less-skilled employees. Education helps create a more valuable and, thus, higher-priced employee.

It makes sense to maximize your value by becoming educated as soon as possible. That way, you have as long as possible to benefit from the increased income. It even makes sense to invest in an education before you sell your labor because the opportunity cost of going to school (in this case, the “lost” wages of not working) is lowest. Without income or savings (or very little) to finance your education, typically, you borrow. Debt enables you to use the value of education to enhance your income; income will then help you pay back your debt.

The alternative would be to work, save, and then get an education, but you would be earning income less efficiently until you completed your education, and then you would have less time to earn your return. Waiting decreases the value of your education, that is, its usefulness, throughout your lifetime.

In these examples (Table 2.4.2 ), debt creates a cost, but it reduces expenses or increases income to offset that cost. Debt allows this to happen sooner than it otherwise could, enabling you to realize the maximum benefit from the investment. In such cases, debt is worth it.

Table 2.4.2 : Debt: Uses, Value, and Cost

Debt	Debt Used to Finance	Value	Cost Paid from
Credit Cards	Living Expenses	Convenience	Income
Auto Loan	Car	Reduce Expenses	Income
Mortgage	Home	Reduce Expenses	Income
College Loan	Education	Increase (Future) Income	Future Income

Summary

• Financing assets through equity means sharing ownership and any associated gains or losses.
• Financing assets through borrowing and creating debt means taking on a financial obligation that must be repaid.
• Both equity and debt have costs and value.
• Both equity and debt enable you to use an asset sooner than you otherwise could and therefore to reap more of its rewards.

Exercises

1. Read about the founding of Google (www.foxbusiness.com/technology/how-google-was-founded), including information about their initial public offering (www.finance.yahoo.com/news/day-market-history-google-ipo-105500069.html) in August 2004. How did the young entrepreneurs Larry Page and Sergey Brin use equity and debt to make their business successful and increase their personal wealth?
2. Record your answers to the following questions in your personal finance journal. What equity do you own? What debt do you owe? In each case, what are your equity and debt financing options? What do they cost you? How do they benefit you?
3. Watch What Everyone's Getting Wrong About Student Loans (www.youtube.com/watch?v=wzY-b2Vj9Ug) (3:45 minutes) and How to Pay for College (www.youtube.com/watch?v=L6cjyTaExCQ) (10:32 minutes). Students fear incurring debt for their education or later struggling to repay student loans.
   1. What are practical financial planning tips to take advantage of debt financing for your education?
   2. If payments on student loans become overwhelming, what should you do to avoid default?

^[1] The Investopedia Team. If You Had Invested Right After Google's IPO. Investopedia, August 13, 2015. www.investopedia.com/articles/active-trading/081315/if-you-would-have-invested-right-after-googles-ipo.asp.