Overview
In the most basic terms, debt financing takes the form of short-term or long-term loans that must be repaid over a specified period of time, usually with interest. Money is borrowed, and usually the borrower (debtor) gives the lender (creditor) a promissory note that obligates the debtor to pay back a certain defined amount at a particular and defined time in the future .
Bank loans as a means of financing
A promissory note dating to 1926 from the Imperial Bank of India, Rangoon, Burma for 20,000 Rupees, plus interest.
With debt financing, the creditor's return is fixed as the agreed upon interest rate for the debt, which varies depending on the perceived riskiness of the debtor. Debt financing usually takes the form of bank loans or bonds.
Bonds
Bonds are a debt security under which the issuer owes the holders a debt. Depending on the terms of the bond, the bond issuer is obliged to pay the bondholders interest and/or to repay the principal (also known as nominal, par or face amount). Most corporate bonds are fixed-rate bonds, meaning that the interest rate stays the same until maturity. Some use floating rates to determine the exact interest rate paid to bond holders. The interest rate paid on these varies depending on some index, such as LIBOR. Other corporate bonds, called zero-coupons, make no regular interest payments at all, but investors still receive returns because these bonds are originally sold at a discount, and then are redeemed at par value upon maturity.
Interest Rate
The interest that the firm will pay ultimately comes down to one factor: at what rate will investors believe the bonds are a good investment? Riskier investments will require compensation for the lender in the form of higher interest rates. Indicators for riskiness can include individual credit histories (for a bank loan) or bond rating by a credit rating company (for corporate bonds). The difference in yield reflects the higher probability of default and liquidity and risk premium.
Capital Structure Theory
The actual effect of the firm's capital structure on firm value is a contested topic in financial theory (see Miller Modigliani Theorem). From a tax perspective, debt financing may have some advantages over equity financing for both investors and the firm. Under a majority of taxation systems around the world, firms are subject to corporate tax and individuals to income tax, leading to double taxation of dividends, if the firm is financed through issuing stock.
For example, a firm that earns 100 dollars in profits in the U.S. would have to pay around 30 dollars in taxes. If it then distributes these profits to its owners as dividends, then the owners in turn pay taxes on this income, say 20 on the 70 dollars of dividends. The 100 dollars of profits turned into 50 dollars of investor income.
If, instead the firm finances with debt, then, assuming the firm owes 100 dollars of interest to investors, its profits are now 0. Investors now pay taxes on their interest income, say 30 dollars. This implies for 100 dollars of profits before taxes, investors got 70 dollars. The firm also benefits considerably, as interest payments can be deducted from the firm's taxable income while dividends and share repurchases cannot be deducted.
It is also postulated that debt makes management more disciplined, forcing them to work harder to ensure that they will make enough to cover their interest payments. These benefits are applicable to both bonds and bank loans. However, costs of debt can outweigh these benefits, depending on the firm. In the event of inability to repay debts, firms go into bankruptcy which is a costly process in itself. Furthermore, the more debt a firm takes on, the more uncertainty it will have about future financing needs: if a firm is already taking on a considerable amount of debt today, where will it get financing for its operations in the future?