Advantages and disadvantages of debt financing

By | June 16, 2013

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1.1    Disadvantages of debt financing to the company

 

Figure 1. Gearing and risk
Source: Needham, D. 1999. Business for Higher Awards. Oxford: Heinemann Educational Publishers. p.112

Financial risk could be to some extent affected by the gearing rate. According to David Needham (1999, p.112) as illustrated in the table above, when a business has stable operating profits which is largely depending on the nature of the industry and nature business that the company is engaging in, a low gearing rate would result in a low financial risk while a higher gearing rate tend to contribute to a medium financial risk; when the business has a volatile operating profit generation because of the nature of the business, the company would still have a medium financial risk with a low gearing rate of the company and volatile operating profit generation and a high gearing rate together make a high financial risk. Based on this table, because high financial risk is not anticipated or desired by the companies, the more volatile the level of business profits, the more marked with will be the effects of gearing. Business that are heavily influenced by economic cycles, such as capital goods suppliers would not normally wish to be highly geared, on the other hand, stable industries such as food producers may be able to provide adequate interest cover at all stages of the economic cycle; they are unlikely to make losses for ordinary shareholders even if highly geared.

 

1.2    Advantages of debt financing to the owners / shareholders

A key advantage of deb finance to the shareholder is the maintaining of the ownership and control of the firm. If a company issue additional common stocks, then in return for the new equity existing owners must give up a portion of their ownership and open up the election of board members, key business decision and potentially the appointment of management to outside investors. This trade-off can be difficult for an entrepreneur who is used to exercising control over the business and has a strong vision for the enterprise (Seidman 2005, p.27). The loss of control in much profitable business is very sensitive and undesirable by the owners. Hence the debt finance is sometimes more favorable to the shareholders.

 

1.3    Disadvantages of debt financing to owners / shareholders

The impact of debt financing is also known as the impact of the gearing, it has impact on the ordinary shareholder on the risk profile. If a highly geared company puts its borrowing to good use, therefore, it will generate enough cash not only to pay the interest on the debt but also to boost earning. However if the company get into difficulties and profit fall it still has to make the interest payments. There may be little or even no money left over for the ordinary shareholders. Shares of highly geared companies are a riskier investment in the sense that the returns are more variable (Chisholm 2002, p.147). The probability of the lose of the profits is the disadvantage of debt financing to the shareholders, the key point here is whether the shareholders have confidence on the long term success of the companies, if the answer is yes then the beginning loss of a project investment could be accepted by the shareholders because anticipated future income should be able to offset the current loss.

 

1.4    Advantages of debt financing to the lender

One major advantage of debt financing to the lender is that the debt financing provides more liquidity in the market. Debt finance and equity finance have different natures. Debt finance, if the obligor has a strong financial position and reliable rating, will give the liquidity to the lender especially if the lending instrument is marketable such as the sovereign bonds and syndication loans. In comparison, equity finance may give access to the management but has more involvement in the borrower’s daily operation which is more time consuming (Huang 2007, p.184).

 

1.5    Disadvantages of debt financing to lender

Conflicts between debt holders and shareholders arise because the debt contract gives shareholders an incentive to invest sub-optimally. If an investment yields large returns that are well above the face value of the debt, shareholders capture most of the gains. In addition, if an investment turns out to be a loss, debt holders must bear the consequences. As a result, shareholders may take on very risky projects at the expense of the debt holders (Baker & Martin 2011, p.80). This effect is also known as “asset substitution effect” and it is a defect of approaching to the debt financing.

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