Debt vs equity financing

Alice explores the relative benefits of two forms of finance, within the framework of buying a house

Imagine you were about to buy a house.

The cost is £100,000 and as luck would have it, last week you won £100,000 on the lottery. So you have the money to pay for the house in full in cash.

However, your bank has told you it will lend you ninety per cent of the price - £90,000 - as a mortgage.

What's more, your boyfriend / girlfriend has already said they are willing to invest as much as you are and share the ownership of the house.

What should you do? Which of these financing options should you take? How much of your lottery money should you invest and how much should you borrow from the bank? And, purely from a financial perspective, how much of your partner's money should you accept?

This conundrum is typical of that faced by companies, investors and their advisors every day in the capital markets when they decide how to finance their existing operations, new projects and M&A deals.

The problem ultimately represents a choice between two forms of finance: between equity versus debt. Your lottery money and that of your partner is equity finance. It is money that you and your partner will invest in the house or elsewhere - at your risk - to seek a return.

The mortgage money, supplied by the bank, is debt finance. It is money that they will lend at their risk, also to seek a return.

The respective proportions of equity and debt that are invested are known as "the capital structure". In general terms, to those investing it, debt is a lower risk / lower return investment, while equity is a high risk / high return investment.

Debt is a loan, lent according to certain conditions. These conditions give the lender three main rights: (1) the right to repayment (2) the right to interest (3) the right to a form of collateral in the case that the debt is not settled. "Collateral" is a form of security to the lender in case the borrower fails to pay back the loan. If you get a mortgage, your collateral would be your house.

Debt is said to be a "senior" claim in the capital structure. In return for limiting their claim for repayment to the amount of the original principal lent, debt holders receive a guaranteed rate of interest and have their claims for payment met before the claims of equity holders.

Like debt holders, equity holders also enjoy three rights: (1) the right to the surplus of capital value after all other claims are met (2) the right to the surplus of income via dividends after all other claims on are met (3) the right to control the company via a vote.

Equity ranks last in the capital structure. In return for accepting the risk that the company might be unable to pay dividend payments or repay their original investment in the event of insolvency, equity holders enjoy the full benefit of any surplus income and capital value accruing to the company after meeting all other claims of operating, interest and taxation expense.

Now let's resolve our house purchase question. The answer is: you should borrow as much as possible on the mortgage, upto the limit where you are confident you are able to service the debt.

In the example above, you should put £10k down as equity, borrow £90k from the bank and not accept any co-investment from your partner.

You will keep your remaining £90,000 in the bank earning interest or invest it in another project that earns a greater return.

This arrangement means you will enjoy maximum "leverage" in that for only £10k of cash you will control an asset worth ten times as much.

If house prices double in the next five years, so that your house is worth £200k, even if you do not pay off any of the £90k mortgage, the difference between the new market value and the debt is your equity, which will have increased from £10k to £110k - a gain of 1000%!

This is exactly the trick that the private equity firm KKR used to buy Alliance Boots earlier this year. Boots was the first FTSE 100 company to be bought out in a so-called "leveraged buy-out". KKR paid a price equal to roughly 11x Boots' profits, but persuaded its financiers to put up 10x this in debt. To control Boots, KKR put in very little of its own money. Therefore, from a purely financial perspective, KKR has risked very little to be in a position to make a spectacular gain. Just as with your house purchase, all the equity upside on the deal will be KKR's to keep.