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Advantages and disadvantages of debt finance
Debt financing refers to how much money the company has borrowed from financial institution to finance its operations and invest in asset creation. Borrowing will come with cost. The cost of debt financing refers to the interest rate charged on borrowed funds (Heerkens 2006, p.23). A contrasting concept is the equity financing which refers to the original money invested by common and preferred shareholders plus new issues of stock as well as all profits retained in the business. This money is seldom repaid. Individuals, investment companies and pension plans are the major purchasers of preferred and common stocks (Pearce, Burgoyne & Humphrey 1977, p.52).
i) To the company
One advantage of using debt financing rather than equity financing is the corporate interest tax shield. In many countries such as the United States, tax laws provide for the company tax detectability of interest paid on debt. No such corporate tax shield is available for dividend payments or retained earnings. Therefore, corporate tax benefits should encourage firms with high effective tax rates and few forms of tax shields other than interests to favor debt financing (Palepu & Healy 2008, p.10). Also because the debt financing comes with deadlines to clear the debts, it will press the management of the company to focus on the value creation activities which helps reduce the conflicts between higher management and the shareholders. As we known, managers have always been known to lead and direct an organization or a company by deploying and manipulating of resources i.e. the human, capital, natural, intellectual and intangible. Shareholders on the other hand are the one who holds one or more shares of stock in a joint-stock company. Conflict of interest happens when both parties want to maximize each benefit. The shareholders want to see higher profits as more dividends can be yield from it whilst the managers are more interested in higher revenue because it means more expenses can be made that are beneficial to them (Helium.com 2007). And because when the company is in debt, managers are forced to create sufficient profit to cover the debts that are due in the future and thus the debt financing ensure that the managers share the same target with the shareholders who reduces the possible conflicts between the management and the shareholders.
Some of the disadvantages of debt financing include the fact that interest must generally be paid on the securities, whether or not the corporation has any income for a particular period. If the debt to equity ratio in a corporation is too high, insolvency of the company is more likely (Schneeman 2010, p.422). And when the insolvency happens and cash flow dries up, a profitable company could be forced to file bankruptcy once the liabilities are due.
ii) To the shareholders
The use of debt financing would assist the shareholders to maintain their control over the company. As we discussed previously, because company has two major option to finance the needs of the business, equity finance or debt finance, if a company chooses the method of equity financing which would usually involves giving voting rights to new investors resulting in less control of the company for the existing stockholders (Porter & Norton 2009, p.575). Also the increase of the stocks will dilute the dividends received by each stock which is not good for the shareholders. In contrast, though the usage of debt financing will generate cost of interest of the borrowing, debt financing would assist the shareholders to maintain their control over the company.
The excess of the after tax rate of the return on assets and the after tax interest rate on the borrowed funds, accrues to the benefit of the shareholders. But the financial leverage can also be a disadvantage if the company does not succeed to earn a rate of return on assets which is higher than the after tax cost of debt, the shareholders will have to support the deficit (Walton & Aerts 2006, p.454). But still such risks seem to be unavoidable because risks to some degree equal to potential high compensations.
iii) To the lender
Debt financing could take several usual forms such as the bank loans and corporate bonds. To the lenders, investment in the corporate bonds has the advantage of higher return rate. For example, because corporate bonds are characterized by credit risk, investors demand a higher promised return on corporate bonds than on safer forms of investments like the Treasury bond. The historical data shows that when corporation bonds were selling around 7.5% (10 year bonds) compared to the 3.5% of the U. S. Treasury bond (10 year bonds) (Tuckman & Serrat 2011, p.527). In addition, corporate bonds also provide flexible interest pay methods which include a fixed rate or a floating rate. The interest rate on fixed rate bonds is set when the bonds are issued and is shown as a percentage of the face value of the bond. The interest rate stays the same for the life of the bond. And floating rate is used when interest rate for the floating rate bonds varies or floats in line with the movements in a benchmark interest rate. The benchmark rate is usually the variable interest rate for a bank bill for a three or six-month term (Rbsmorgans.com 2010). The two options of interests meet different investor needs to secure the interest or follow the market benchmark changes.
Unlike equity, debt must be repaid even when a firm’s revenue declines or cost rise unexpectedly. These fixed payments reduce monies available to reinvest in the business to improve earnings and can generate financial hardship when earnings decline. Debt payments that exceed a firm’s cash flow and cash reserves can lead to bankruptcy or in the worst case, liquidation of the firm’s assets to repay debt holders (Seidman 2005, p.32), i.e. the lenders. This constrain is even more detrimental to companies borrow money during the time of credit crunch and when many business could not raise capital through the formal capital rising channels.