Financial leverage is using borrowed funds to increase revenue producing assets. This is done with the hopes that the increased income will be more than the cost of borrowing. Using debt financing allows a business owner to benefit from financial leverage. If a business borrows money at 4% and reinvests it with a return of 10%, revenue benefit from the 6% spread.

Moreover, interest expense is tax deductible further reducing the cost of borrowing. If a business owner, borrowed money from an investor, dividends paid to the investor is not tax deductible. Also, when you sell equity, you give away a part of your company which is something you don’t have to do with debt borrowing.

Let us take a look at an example:

ABC Co. has the option to bring in new investors or get a bank loan. The principal amount needed is 100,000 dollars. The bank will loan this money at 4%. ABC co. has a tax rate of 25%. The equity investors also require 4% annual dividends. Let us take a look at the effect of debt financing over equity financing:

Debt financing results in less taxes and also an increase in retained earnings. Regardless of using debt or equity financing, ABC will need to pay 4,000 dollars as either dividend or interest. However with equity financing there is no tax benefit of paying out the 4,000 dollars while with debt financing there is a tax savings of 1,000 dollars.