The risks of raising additional finance through an overdraft facility were highlighted in the second half of 2007, when big banks passed on their own rising cost of borrowing and added their own risk premium. Businesses accustomed to financing working capital with an overdraft reported encountering interest rates to 10-11%, a jump of up to two percentage points, according to the Federation of Small Businesses.

If borrowing is targeted at a specific investment, with a business plan or rate-of-return calculation attached, loan costs can be cut by using a specifically arranged loan rather than adding to the overdraft. Whether taken as a specific additional loan from a single source, a syndicated loan (spread across several lenders), or a bond issue, the cost can be brought down by specifying the purpose in prospectus, and offering collateral that guarantees the lenders a recovery of their capital even if that purpose fails.

Funds for working capital can also be raised as trade credit – the loans implicitly taken from customers by taking payment ahead of delivery, and from suppliers by taking delivery ahead of payment. For a limited period such loans are interest-free; beyond it, there may be penalties or interest owing for late payment. The short duration of such loans limits their appropriateness for fixed investment, but they may become appropriate for this if continuously rolled over.

Security
Loans were traditionally secured against land, buildings, or other assets that could easily be seized and sold by the creditor if the borrower defaulted. Although these are still popular forms of collateral, the range of assets that can fulfil this function is now much broader. In particular, many receivables can now be collateralised into packages that, because they deliver a regular income flow, offer security for a loan.

Factoring services have long been available which collateralise the order book, by selling orders to a specialist who advances capital in return for the right to collect the payment. The range of future cashflows that can be collateralised has now been widened considerably, which is why in the UK the Factors and Discounters Association renamed itself in 2007 the Asset Based Finance Association. In effect the future income from (for example) regular sales, rental income or interest paid on customer loans can be brought forward by borrowing against it.

Costs of equity and debt
In principle, raising debt should be cheaper than raising the equivalent amount of equity because:

• it has a tax advantage: the return on debt (interest) counting as a cost that is deductible against tax, whereas the return on equity (dividend) is taxed as profit before it can be returned
• it is less risky for investors: as payments on equity are discretionary (whereas interest on debt is paid according to a set rate and schedule), and because shareholders (even with limited liability) must queue behind creditors for reimbursement if the company goes bankrupt, equity investors demand a "risk premium".

The cost of external shares is marked-up over the risk free rate of return, which is typically taken as the interest rate on government bonds. Interest rates on corporate bonds tend also to be marked-up over the risk free rate, but not by as large a premium, because doubt can arise only about the ability of the company to repay and service its debt, not its willingness to do so.

However, the risks to creditors rise as debt issuance proceeds. A more highly leveraged company is more likely to run into cashflow problems (because it must channel earnings to interest payments over which it has no control), and less likely to be fundamentally solvent in the sense of being able to repay all its debts from realisable assets. Therefore the cost of debt rises as its proportion rises in relation to equity.

The risks to shareholders also rise as debt issuance proceeds, because increased creditor claims on the company’s capital and earnings increase the amount of these that will disappear into debt service and repayment, and the risk of shareholders’ equity being lost in the event of bankruptcy. It has been argued, on the basis that increasing debt causes a rise in the yield on equity, that issuing more debt and raising the gearing ratio (of debt to total capital) makes no difference to the firm’s cost of capital. This argument (the ‘Miller-Modigliani theorem’) suggests that the debt and equity will have the same costs at the margin.

In practice, this argument ignored the tax advantages of debt, which make it cheaper than equity when the gearing ratio is low; and the rising bankruptcy risk of debt, which make it more expensive than equity when the gearing ratio is high. It also requires highly efficient capital markets in which investors can easily buy or sell shares in order to raise or repay equivalent amounts of debt. So there is still a point above which issuing equity is cheaper than taking on more debt, with retained profit offering a cheaper equity source than the external sale of shares.

Governance consequences of equity and debt
For the company and its management, issuance of debt can have governance advantages even after its cost has started to rise. In the UK (and US), creditors do not exercise the same strategic influence as shareholders, who can usually appoint boardroom representatives and vote on key policies. So credit becomes especially important to companies which wish to retain a mutual or cooperative structure (owned by their original depositors, employees or customers), or are trying to stay under founding family control.

Because it makes managers more accountable for strategy and financial performance, external shareholding has traditionally been seen as a discipline on the running of the company, which can make people willing to supply capital at a lower cost. However, this depends on shareholders being sufficiently concentrated and ‘active’ to monitor the management and intervene if it is seen to underperform. The wide spread and loose coordination of shareholders has generally worked against such active governance. As creditors are often fewer in number and better coordinated, and can impose more rigid payment schedules, raising leverage can ensure greater managerial discipline. Once dispersed shareholders look to more concentrated shareholders as a source of discipline, raising a certain amount of capital through debt can actually make it cheaper to raise the rest through equity, because shareholders’ risk premium is reduced.

Choosing the type of debt
For large investments, the principal choice is between taking the loan from a chosen creditor or creditors (usually a bank), or selling the loan as a bond that will be underwritten by banks but sold to wholesale or retail investors.

The main advantage of a bond is that its re-tradability may improve the lender’s terms, obtaining the same sum for a lower cost. Disadvantages can arise from the higher initial cost of arranging a bond issue, and the pressure on governance exerted by the bond market. Re-tradability enables bondholders to sell if they cease to believe in the form’s profit prospects, making the bond price into a real-time comment on market expectations of performance.

Although costlier to issue, bonds can raise capital at lower cost than other loans because they open the investment to a wider pool of subscribers. Issues are graded by credit rating agencies, on the basis of the likelihood of all interest being paid and principal returned on time. Provided investment grade is assigned, the bond can be purchased by a large number of ‘mainstream’ investment funds, as well as individuals.

Loans raised from a bank (or syndicated across several banks) can also, in principle, be retraded. But this is generally only done if the company fails and the loan becomes nonperforming, at which point the bank may cut its losses by selling it at discount to a specialist distressed-debt investor. At other times, under the UK and US system, the bank retains responsibility for the loan but does not become involved in corporate dealings on decision making.

Fixed or floating rate?
Whether borrowed from a bank or issued to bondholders, debt can be given either a fixed interest rate for a specified period or a floating rate linked to an agreed index. For the borrower, fixed-rate debt has the advantage of giving an exact cost profile across its lifetime, so that principal and interest payments can be precisely budgeted each year. However, its costs will tend to be higher than an equivalent sum raised at floating rates, because creditors need to be compensated for future inflation that will cut the real cost of the repayments. Given that they cannot raise the interest rate during the lifetime of the loan, they will usually set the rate higher than the present floating rate, unless there is a strong expectation of the inflation rate falling.

Floating-rate debt is usually set as a mark-up over the base rate set by the central bank in charge of the currency being borrowed – in the UK, the Bank of England base rate. The borrower must therefore be prepared to pay more if monetary policy tightens and interest rates rise during the period of the loan, as will tend to happen if inflation accelerates. Because inflation is the principal reason why interest rates rise, the floating rate will sometimes be linked directly to the inflation rate.

Fixed-rate debt becomes advantageous if inflation accelerates unexpectedly, because lenders will have set a lower interest rate than if they saw the faster price-rises coming. Conversely, a fixed rate becomes disadvantageous if inflation unexpectedly slows, or if there is an unanticipated cut in floating interest rates for any other reason. In this case it may be possible to take out another loan at lower rates to repay the first loan early, but the cost saving from doing so is reduced if the lender has inserted an early-repayment penalty. The fixed costs of closing one loan and arranging another can also reduce the cost advantage from such refinancing.

Knowing the limits
If you are confident that cashflows will stay strong enough to meet interest obligations and avoid intervention by the creditor, then negotiated debt can usually undercut the cost of equivalent equity in the early stages of a company’s development. If you are unsure that the timescale for generating cash will be as short as the timescale on which lenders will expect theirs, there is a case for looking more closely at equity options.

Prospective creditors will do some of this thinking for you, restricting the length of the loan and pushing up its interest rate if they suspect that earnings are getting uncertain or gearing going too high. But remember that creditors worry only about recovering their investment, not about the survival of the business. If you need external finance with a more flexible payback expectation, equity placement may be the direction to go.