Advantages and disadvantages of debt financing
A new business venture requires finance throughout its operation. A firm usually raises money for working capital requirements and also for making capital expenditures. It usually achieves this by selling debentures, bonds, bills, or promissory notes. Sometimes they seek financial assistance from outside companies or other organizations for raising additional capital. They could also decide to approach the public through IPO’s (Initial Public Offerings). Financing decisions need to be made by the company according to the characteristics of their financial needs and repayment capabilities.
The organization should choose the right financing strategy according to their company’s rules, policies, and regulatory norms. They can either go for debt financing or they can seek equity finance. Or they could seek a judicious blend between the two.
First of all, it is necessary to discuss what debt and equity financing are, and how they could impinge upon the company’s financial structure and professed objectives.
Debt financing
Fundamentally, debt financing means borrowing money from outside sources under the condition that it will be repaid at a fixed period of time in the future usually for a definite rate of interest. The term debt means money that is owed to somebody else. There are many advantages as far as debt financing is considered. The biggest advantage is that the lending person will not get any ownership of the loanee business so that maximum control can be retained over the business by present owners. The commitment to the lending party would be in terms of having to repay the debt on schedule in time with fixed interest.
Another advantage of debt financing is that it is tax-deductible.
Debt financing has got many disadvantages also. The main disadvantage is that the business could not use its entire cash to run the business and also from the interesting point of view which might be higher in most of the cases. The firm may even sometimes lose future flexibility due to enforcement of equity ownership and resultant dilution of share ownership.
Debt financing
Debt financing can be broadly divided into two broad categories according to the type of debt that is being searched for. It includes long-term or short-term financing. The long term finance is generally acquired for purchasing assets for our business such as equipment, building, land, and machinery.
In long-term financing, the repayments extend to a period exceeding one year. Short-term financing can be for a period of less than one year and is acquired for day-to-day operations of the business, such as the purchase of raw materials, paying wages, etc. Equity financing is also a financing technique that does not involve any outside debt. It is usually done by selling stock to individual stakeholders or institutional investors. In this case, the business is receiving funds from the investor since the business is sharing ownership with the investor. (Creative Capital Associates: Financing vs. Equity vs. debt).
In order to balance our decision between debt and equity financing, the debt-equity ratio need to be worked out. The amount of debt should be compared with the amount of equity. This ratio is very important from the point of view of lenders, in the sense that it gives a real idea about the money available for repayment in case of default.
The use of debt financing generally increases the shareholder’s rate of return. Usually, the debt holder gets top priority for receiving the returns in the form of repayment of principal and interests. If any default is been made on the repayment to the debtors, the firm may be made bankrupt by debt holders through legal processes.
Use of debt financing affect rate of required return
The equity shareholders hold an advantageous position in that they will be paid higher dividend rates since they can demand a higher risk premium. As the company issues more debt, the shareholders can demand a higher rate of returns in the form of a dividend. The shareholder’s demand could be met only if the company goes for undertaking riskier, albeit more profitable projects.
The Miller-Modigliani Theorem
The Miller-Modigliani Theorem clearly explains the concept that if a firm is not having any tax obligations, default risk, or agency risks, the capital structures themselves become irrelevant, which means the firm is independent of its debt ratio. The cost of debt is the market interest rate that the firm has to pay on its borrowing. This will mainly depend on three components like the general interest rates, the default premium, and the firm’s tax rate. (Finding the right financing needs: Miller –Modigliani Theorem: The capital structure design P. 23).
Optimal Capital structure
Optimal capital structure means that the firm should have an optimal mix between debt and equity financing, which means there should be a trade-off between the debt and equity. The simplest way to measure the firm’s financing mix is just to look at the amount or the proportion of the debt that the firm is using in the total finance. This could be finding out by using the Debt to capital ratio.
- Debt-capital ratio = Debt / Debt+ Equity
The company has to choose the mix based on its policies. If the company is facing a higher marginal tax rate, then the company should have more debt financing in its capital structure. For example, real estate corporations have higher debt ratios.
A firm that is not going for debt financing means that it generates higher income and cash flows each year. If adequate cash flows are not made, it will lead to incompetent management which may affect its overall performance.
Besides equity capital could be used for expansion programs, diversification, and business acquisitions, including setting up of overseas offices and branches.
The management should take into consideration that the investments, either in debt or equity, should earn at least enough to cover the fixed interest expenses. Considering another case, if the firm is on the road to bankruptcy, it should go for less debt financing, according to the given level of debt. If the firm is facing some agency problems, the firm should use less debt financing. This is because debt financing is a binding and mandatory payment that has to be extinguished irrespective of the presence of adequate cash inflows, cash profits, or not. In the event debt payment is not serviced, the creditors could seek a court order to wind up the company, sell its assets and recover their dues from it.
Case Studies
Tesco: Tesco is the UK’s leading supermarket chain. It has made strong financial progress in the international market over the years. It has delivered high growth in turnover, profits, and returns over the years. Its sales were up by 23% to £9.2 billion and profits up by 17.4% to £465 billion. (Tesco: Annual review and summary financial statement 2006). The directors have also proposed a final dividend of 6.10% to the shareholders, which brings a full-year dividend per share to 8.63%.
The future line of dividends will depend upon earnings per share (EPS). (Tesco: Annual review and summary financial statement 2006). Since the sales and profits are really high for Tesco, it is not essential to go for debt financing, even with present equity financing, the business could be run. However, with the approval of their Board of Directors, they could consider expansions and acquisitions with debt capital.
Intercontinental Hotel Group (IHG): It operates in the global hotel market that is presently in the process of restructuring and reducing the number of hotels owned. Annual group turnover during FY 2006 is £ 201M. (InterContinental Hotels Group: Annual Review and Summary Financial Statements 2006.)
The share holders’ returns are also increased to£ 2.7B; a further £31 M remains to be returned through their ongoing share buyback programs. The Group has announced an £850M return of funds comprising of £100M share buyback and £ 700M special dividend with a proposed share consolidation. (Source: financial performance and financial mix of intercontinental hotel group)
Since the Group is restructuring its capital base, they can better go for debt financing. They have also got enough funds to run the existing business from the sales proceeds. So the company can better adopt a judicious blend of debt and equity financing for future needs.
Sony Electronics: Sony Electronics (US) is a major player in the global contract manufacturing industry with operations in a wide variety of products and services in the field of entertainment electronics, and also Electronic items and PCs. Sony Electronics (US) is a major player in the global contract manufacturing industry with operations in a wide variety of fields, including HDTV, Electronic items, and PCs. Even though Sony experiences tremendous growth over the past 60 years, its organizational structure had become fragmented with limited integration and needs to be revitalized. Massive cost reduction schemes are on the anvil to make Sony even more competitive in global markets (New Management’s Mid-Term Corporate Strategy :
Cited Works
(Creative Capital Associates: Financing vs. Equity vs. debt). Web.
Access Commercial Mortgages. Web.
Finding the right financing needs: Miller –Modigliani Theorem: The capital structure design( P. 23). Web.
Tesco: Annual review and summary financial statement 2006. Web.
(InterContinental Hotels Group: Annual Review and Summary Financial Statements. 2006. Web.
(New Management’s Mid-Term Corporate Strategy. Web.