The Risk Created by the Use of Debt
One must consider the various risks associated with using debt; failing to repay the loan is a significant concern. When a company takes out loans or borrows funds from lenders but fails to make timely repayments, it puts itself at risk of legal action and asset seizure by those lenders (Bărbuță-Mișu & Madaleno, 2020). Additionally, if a firm defaults on its debt, it can negatively affect its credit rating and cause higher lending expenditures later.
Financial trouble may ensue from using debt. The firm’s worth might suffer a setback if this puts off lenders and shareholders; in like manner, bankruptcy is a possible outcome for firms experiencing financial difficulties that could cause them to dispose of their properties and cease business operations. Debt use can lead to higher levels of volatility in the firm’s stock price as financial leverage is increased when taking on debt, which increases the volatility of a firm’s stock prices (Bărbuță-Mișu & Madaleno, 2020). Stock prices tend to be affected by fluctuations in the company’s profits when more significant portions of their income are used for repaying debts, and smaller portions are available for distribution among their shareholders.
There is a chance of facing liquidity risk when utilizing debt. If an enterprise acquires debt, it may not have enough money to meet its short-term obligations, including remunerating its suppliers and workforce. This situation would result in cash flow problems and the incapacity to meet their existing monetary obligations, causing them to experience severe financial hardship.
Effect of Adding Debt on the Value of the Firm
Debt usage significantly impacts how firms’ value is evaluated by multiple means, and debt employment could elevate a firm’s value by increasing potential investment returns for shareholders. One benefit of borrowing through debt financing is a firm’s ability to increase profits and provide higher returns for shareholders via leveraging assets (Yuniningsih et al., 2019). Besides that, employing debt could lead to increased risk for the firm, too, just like what was said previously. If shareholders take an aversion because of increased risks, there is a reduction in firm valuation due to an escalation of danger. At long last, utilizing borrowed capital can raise financing costs for the company; whenever an enterprise borrows money through loans, they are required to pay interest, which can shrink its profits and hike up its capital costs (Yuniningsih et al., 2019). A decrease in value can occur when investors are reluctant to purchase stock from firms with high capital costs, such as this one.
References
Bărbuță-Mișu, N., & Madaleno, M. (2020). Assessment of bankruptcy risk of large companies: European countries evolution analysis. Journal of Risk and Financial Management, 13(3), 58. Web.
Yuniningsih, Y., Pertiwi, T., & Purwanto, E. (2019). Fundamental factor of financial management in determining company values. Management Science Letters, 9(2), 205-216.
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