When playing the Business Strategy Game (BSG), none of the companies have much money in year 11. Companies need to raise funds using either debt or equity. By financing your company via debt, you accept risk of bankruptcy. Bankruptcy occurs if you default upon your loan for 3 consecutive years. Defaulting upon your loan also causes your credit rating and stock price to drop. Equity is the alternative to debt in raising capital through the sale of common shares. The loss of shares decreases your Return on Equity ratio (ROE) and Earnings Per Share ratio (EPS). The advantage of selling equity is that there’s no risk of bankruptcy.
I have learned an intriguing strategy from 2 successful Industry Champions. The strategy is to build a financially strong company and sell shares when the stock price is high. Then after purposefully executing a bad fiscal year, buy back the shares when the stock price has sunk. This allows your company to gain huge amounts of capital using a “build and sink” strategy for your company on a manipulated stock price. This is terribly risky and rather unethical, but also innovative and it catches most companies off guard. The concept of people buying shares low and selling shares high is worth noting when raising funds via equity.
Raising capital through debt is the traditional way of raising money which completely exposes your company to bankruptcy. However, debt financing can be cheaper than equity financing with an extremely profitable company because money can be repaid at a fixed annual rate while buying back shares can become expensive with a rising share price. The great disadvantage that debt has is that it can weaken the profit margins annually through interest expense – a feature that equity does not have.
Both debt and equity have their advantages and disadvantages when raising capital. Finding the right debt to equity ratio will help your company finance it’s growth and profitability to win the Business Strategy Game.