Evaluation Of Debt And Equity Funding

3) The interest resulting from the debt also will cost to the company even it is taxable. The interest is fixed base on the level of the debt even the company does not generate profit. This would need to be careful when take on the debt comparing to use its own capital. And the creditor may come to intervene on the business when the company has difficulty to service its debt.

In debt financing the interest expense is allowable expense resulting in low tax expense, where as in case of equity finance the cost of equity is dividend, and no advantage can be availed in tax.

2. Forecast the firm’s financial statements for 2002 and 2003. What will be the external financing requirements of the firm in those years? Can the firm repay its loan within a reasonable period? In order to forecast the financial statements of 2002 and 2003, the following assumptions need to be made. The growth of sales is 15%, same as 2001, which is estimated by managers. The rate of production costs and expenses per sales is constant to 50%. Administration and selling expenses is the average of last 4 years. The depreciation is $7.8 million per year, which is calculated by $54.6 million divided by 7 years. Tax rate is 24.5%, which is provided. The dividend is $2 million per year only when the company makes profits. Therefore, we assume that there will be no dividend in 2003. Gross PPE will be $27.3 million (54.6/2) per year. We also assume there is no more long term debt, because any funds need in the case are short term debt, it keeps at $18.2 million. According to the forecast, Star River needs external financing approximately $94 million and $107 million in 2002 and 2003, respectively. In order to analysis if the company can repay the debt, we need to know the interest coverage ratio, current ratio and D/E ratio. The interest coverage ratios through the forecast were 1.23 and 0.87 respectively, which is the danger signal to the managers, because in 2003, the profits even not

Now, the advantages of debt capital centre on its relative cost. Debt capital is usually cheaper than equity because, the pre-tax rate of interest is invariably lower than the return required by shareholders. This is due to the legal position of lenders who have a prior claim on the distribution of the company’s income and who in liquidation precede ordinary shareholders in the queue for the settlement of claims. Debt is usually secured on the firm’s assets, which can be sold to pay off lenders in the event of default, i.e. failure to pay interest and capital according to the pre-agreed schedule;

There are several factors that guide the choice among debt financing and equity financing such as potential profitability, financial risk and voting control. Equity financing is a method used to obtain capital in order to finance operations, growth or expansion. Sources of equity financing are extremely important. Major sources of equity financial are Retained Earnings, sale of stock, and funds provided by venture capital firms. Profits that are kept and reinvested are called Retained earnings, which is a very attractive source fund due to the savings it provides to the entity by not paying the interests, dividends or underwriting fees related to issuing securities. This source of financing does not dilute ownership, but it

Increasing amount of borrowing despite of its consistent profitability came from following reasons. First is the firm’s financial position. As sales have increased by 60% from 1993-1995, the assets that support increase of sales increased by 78% (Exhibit 1 & 2). The increase amount of assets is over the amount of net income (addition to net worth). To meet financial needs, the company received short-term loans from bank, $60 in 1994 and $390 in 1995 (Exhibit 2). The gross profit

debt. The steady cash flow generated by the business, short-term bank loans, and the proceeds of the

firm’s financing, for example, issuing or repurchasing stock and borrowing or repaying loans. It also

If the financing of the project comes partially from issuing debt and cash infusion from the owners, the available cash will increase without as much interest expense. This will cause the company books to look bad because of lower EPS, however the company will have a choice not to pay dividends if necessary rather than being bound to pay interest expense.

The advantage of debt financing is that interests paid on such debt are tax deductible. If a company has the intention of maintaining a permanent debt, the present value of the tax shield can be obtained by discounting them by the expected rate of return demanded by the investors who hold the debt (this is a perpetuity, where in reality would be the maximum possible present value for the tax shield). This tax shield value reduces the tax bill and increases the cash payment to investors, increasing the value of their investments.

Firstly, interest on debt is tax deductible, therefore, debt is the least costly source of long-term financing as this is a tax saving for the frim. Thus, creditors or bondholders require a lower return on debt as it is considered a reflectively less risky investment. Secondly, the capital structure of a firm is flexible due to debt financing. Ultimately, bondholders are creditors and they do not have voting rights, hence, they are not involved in decision making and business operations. Additionally, the major advantages of equity finance are as follows. Firstly, the capital provided is to finance the businesses short term needs and future projects. Secondly, the business will not have to pay any additional bank expenses such as interest on loans, thus allowing the business to use the money for business activities. Lastly, investors anticipate that the business will develop thus they help in exploring and executing thoughts. Certain sources, for example, venture capitalists and business angel can bring significant skills, abilities, contacts and experience to businesses and they can also provide expertise advice to businesses (Hofstrand,

There are two basic ways of financing for a business: Debt financing and equity financing. Debt financing is defined as 'borrowing money that is to be repaid over a period of time, usually with interest" (Financing Basics, 1). The lender does not gain any ownership in the business that is borrowing. Equity financing is described as "an exchange of money for a share of business ownership" (Financing Basics, 1). This form of financing allows the business to obtain funds without having to repay a specific amount of money at any particular time. There are also a few different instruments that could be defined as either debt or equity. One such instrument is stock options that an employee can exercise after so many years with the

U.S. Semiconductor, a semiconductor manufacturer decided to expand their business to UK market in 1980. Their new business plan needed specialized technical support facility in UK. In order to minimize the equity investment, they decided to fund their assets mostly with debt. As Semiconductor owned subsidiaries, which spread all over the world, they face great exchange risk. Besides, instead of building a production department in UK, Semiconductor kept producing their products domestically and delivered them to UK by plane. British firms also confronted exchange risk due to the difference between import costs and sales revenues. This case mainly involves the discussion on the method of debt funding.

Harris and Reviv (1990) gave one more reason of using debt in capital structure. They say that management will hide information from shareholders about the liquidation of the firm even if the liquidation will be in the best interest of shareholders because managers want the perpetuation of their service. Similarly, Amihud and Lev (1981) suggest that mangers have incentives to pursue strategies that reduce their employment risk. This conflict can be solved by increasing the use of debt financing since bondholders will take control of the firm in case of default as they are powered to do so by the debt indentures. Stulz (1990) said when shareholders cannot observe either the investing decisions of management or the cash flow position in the firm, they will use debt financing. Managers, to maintain credibility, will over-invest if it has extra cash and under-invest if it has limited cash. Stulz (1990) argued that to reduce the cost of underinvestment and overinvestment, the amount of free cash flow should be reduced to

This project is a part of the Management of Business Administration course being taken up at School of Business, Galgotias University, Greater Noida.