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Debt or Equity? A Quantitative Approach

At Altimapa we are often asked about what is the cheapest form of funding: debt or equity? In this blog post, we take our quantitative axe to the problem.


Many of our readers will wonder if talking about the "cost of equity" even makes sense. Indeed debt carries interest and needs to be repaid at some point. On the other hand, giving away equity carries no obligatory costs. However, when it comes the time to exit or buy-back shares or even pay dividends, then an equity holder will demand its fair share of the proceeds. Beyond the purely financial, equity will also carry rights to dividends and a degree of control over the way the company is run.

In this blog post we focus on the financial cost: if one is faced with the lucky choice of funding a company with either equity or debt, what is the ultimate payback in each case? In other words, which is the most profitable alternative for the business owners over the medium and long term?

The Analysis

To answer the question of which structure is most efficient, we made certain assumptions:

  1. The owners or board have a forecast or a least an opinion of how fast the company will grow over the coming years
  2. We consider a time horizon of 5 years
  3. All new cash is going into growing the business (i.e. not for a cash-out or dividend recapitalisation). That growth can either be organic or not
  4. If funding with debt, the structure will be a structure that is typical in alternative financing transactions: a fixed interest rate loan, with or without warrants. The loan may be amortising or not
  5. If funding with equity, it will be ordinary equity without any preferred features (the latter is in practice a blend of equity and debt)

It is also worth pointing out that the actual amount of new funding is not relevant here because we are looking only at relative costs of either solution, not the absolute values.

The Results

With these simplifying assumptions, we can estimate the all-in cost of funding in each case and we can then rerun the calculation for a range of parameters such as the growth rate and the cost of debt.

With regard to the latter, the lower the target leverage, higher the availability of tangible assets and longer the track record, the closer to the left hand side will a debt solution be found. On the opposite end of the spectrum, we generally find that lenders will introduce the concept of a warrant. These are most common where a debt facility is offered to high growth companies with no tangible assets, higher leverage and sometimes a short (or no) track record of cash generation. The percentage shown in the 'Warrant' row is the proportion of undiluted equity that the warrant has a right to.

We represented the results as a heatmap of the relative benefit of each solution: the colour green represents areas where (from a purely financial perspective) debt is preferred and red represents areas where equity is the cheaper option (i.e. red = choose equity, green = choose debt). White represents areas where the two solutions are economically equivalent.

When reading the heatmap, it is assumed that any growth "stays" in the business. If dividends are to be paid (or other kinds of distributions made), then the dividend rate should be added back to the growth rate, to arrive at an underlying real rate of growth.



The outcome is what one could expect: if the growth rate of the company is large, equity (which has unlimited upside) becomes relatively more expensive than debt (capped upside); if interest is larger, the advantages of debt become smaller and introducing a warrant further reduces the economic benefit of debt.

On the whole, for a company that expects to grow at a reasonably high rate (10% or more) there are few scenarios where equity is the more attractive alternative. Indeed, for a large majority of growth and interest rate scenarios, the debt alternative (in green) is preferred. This situation is likely to be further exacerbated in the real world where the underlying rate of growth of many companies is "hidden" by the payment of dividends and other shareholder distributions (as discussed earlier, that should be added back to calculate a real rate of growth).

In the analysis above, we tried to start from a fairly generic set of assumptions that we hope will apply to a large number of companies. Please get in touch if you would like us to recalculate the heatmap for conditions that most accurately reflect your business. Altimapa can also provide you, your board or management team with an initial assessment of the potential financing structures that would be available to your business. In the meantime, please visit our web page to download the latest private debt market update and check other posts in the blog.