Introduction to Debt

Introductory Material

Foundations

What debt is and why it exists as a strategic tool in corporate finance.

Foundations

What Is Debt?

Borrowed capital with a contractual obligation to repay the principal amount plus interest over a defined period
Unlike equity, debt does not confer ownership in the business. The lender has no claim on future profits or decision-making authority
"It is a contract, not a partnership." The terms are fixed and enforceable regardless of how the business performs

Key distinction: Equity investors share in both the upside and downside of a business. Debt holders receive a fixed return and get repaid first. But that's all they receive, no matter how well the business does.

Foundations

Debt as a Strategic Tool

Most people associate debt with personal borrowing (credit cards, mortgages, student loans) where it often feels like a burden
In corporate finance, debt is a deliberate, strategic choice used by sophisticated companies and investors to create value
Companies don't borrow because they lack capital, they borrow because, when used correctly, debt improves financial outcomes
The rest of this module explores why and when debt creates value

Foundations

Why Use Debt?

Leverage

Amplify equity returns by controlling more assets with less of your own capital.

Preserve Ownership

Raise capital without giving up equity, retaining ownership, control, and future upside.

Cost Efficiency

Debt is often cheaper than equity due to repayment priority, collateral, and the tax deductibility of interest.

Flexibility

Debt can be structured to match virtually any need or timeline, from daily working capital to decade-long bonds.

The Four Reasons

A closer look at each motivation for using debt.

The Four Reasons

Leverage: Amplifying Returns

Debt allows you to control more assets with less of your own capital
When the return on an investment exceeds the cost of borrowing, the excess accrues entirely to equity holders
This is the core motivation for investors; private equity firms doing LBOs, real estate investors, and portfolio managers expanding their asset base
Leverage works both ways: it amplifies losses just as effectively as gains, which is why lenders care deeply about how much leverage is being used

The Four Reasons

Leverage in Practice

Same Business, Different Returns

Both scenarios assume the same company purchased at $100M and sold at $130M after 3 years. The only difference is the capital structure.

With leverage, equity holders invested $40M and received $59.2M after repaying debt and interest. A 48% return versus 30% with all equity.

Note: Interest expense ($3.6M/year × 3 years = $10.8M) must always be deducted. Leverage amplifies returns net of borrowing costs, not gross.

The Four Reasons

Preserve Ownership

Issuing equity means giving up a share of the business's ownership, control, and future upside
Debt lets you raise capital while existing owners retain their full stake
A founder scaling their company can fund growth without surrendering equity to new investors
A public company can fund an acquisition without diluting earnings per share for existing shareholders
A distressed company can raise capital without issuing equity at depressed valuations that would devastate existing owners

The Four Reasons

Cost Efficiency

Lenders accept lower returns than equity investors because they have repayment priority and often hold collateral
Debt has a contractual cost (the interest rate); equity has an implied cost (the return investors demand for taking ownership risk). Different concepts, but comparable for capital allocation
Interest payments are tax-deductible, creating a "tax shield" that further reduces the effective cost of borrowing
This makes debt economically attractive even when a company could use equity; the motivation is minimizing total cost of capital

Example: A company with strong cash flows might borrow at 5â€“7% while equity investors demand 15-20% expected returns. Rational capital allocation means using the lowest-cost source available.

The Four Reasons

Flexibility

Revolving Credit

Can be drawn and repaid as needed, functioning like a corporate credit card for day-to-day working capital.

Bridge Loans

Short-term financing that covers timing gaps between a transaction closing and permanent financing being arranged.

Long-Term Bonds

Lock in fixed costs for years or decades, giving certainty over future interest expense.

Key contrast: Equity is permanent and rigid. Debt can be tailored, temporary, and purpose-built, which is why it shows up in virtually every corporate finance situation.

The Trade-Offs

The risks of debt and the lender's perspective on the transaction.

The Trade-Offs

Obligation and Risk

Balancing Benefits and Risk

Unlike equity, debt must be repaid regardless of business performance. Miss an interest payment and you're in default.

Too much debt relative to cash flow creates financial distress. The entire discipline of debt structuring exists to find the right balance.

The Trade-Offs

The Lender's Perspective

Why Lenders Provide Debt

Lenders deploy capital in exchange for predictable, contractual returns. They don't share in the upside if the business succeeds wildly, but they get paid first if things go wrong.

Collateral, covenants, and repayment priority all exist to protect the lender's capital.

The Trade-Offs

What Determines Capacity?

Cash Flow

Can the company generate enough to cover interest and principal payments? This is the primary driver of lending capacity.

Asset Base

What can the lender seize and sell if the borrower can't pay? Tangible assets like property and equipment provide stronger collateral.

Existing Debt Load

What's already claimed against those cash flows and assets? A company generating $50M with $200M of existing debt has very different capacity than the same company with no debt.

Market Conditions

In strong markets, lenders compete and terms loosen. In downturns, they pull back. The same company may borrow more or less depending on when it goes to market.

Key insight: This is why leverage levels vary widely, an LBO might use 6x EBITDA while a growth company gets 2x. It reflects the borrower's repayment profile, not an arbitrary number.

Where Debt Shows Up

Mapping motivations to real-world applications.

Where Debt Shows Up

Motivations Overlap

Application	Leverage	Preserve Ownership	Cost Efficiency	Flexibility
LBOs	•		•
M&A Financing		•	•
Growth Capital		•	•
Distressed Capital		•	•
Working Capital				•
Bridge Financing				•

Key point: The same transaction can be driven by multiple motivations depending on the company's situation. An acquisition might be leverage-driven (PE buyout), ownership-preserving (public company), and cost-driven (cheaper than equity) all at once.

Summary

Bringing It Together

Debt is a spectrum of tools, not a single product, serving different purposes across corporate finance
Borrowers use it for leverage, ownership preservation, cost efficiency, and flexibility
Lenders provide it for predictable, protected returns and their willingness to lend shapes what's possible
The "right" amount of debt balances these benefits against the fundamental risk of mandatory repayment

Next module: Introduction to the Debt Capital Structure: the specific instruments that make up a debt package, how they're layered, and why each exists.