Question

Understanding Finance (30%):

The CEO needs you to explain the following concepts which deeply trouble him:

a. What is advantage and disadvantages between raising money from debt and equity?
b. What is purpose of Treasury shares?
c. Explain the benefits and downside of different depreciation policies such as straight line and declining method?
d. Explain what is financial leverage and its advantage and disadvantage.

Answer 1

a) advantage and disadvantages between raising money from debt and equity.

Answer:-

Advantages of Debt Compared to Equity

1) Because the lender does not have a claim to equity in the business, debt does not dilute the owner's ownership interest in the company.

2) A lender is entitled only to repayment of the agreed-upon principal of the loan plus interest, and has no direct claim on future profits of the business.

3) Interest on the debt can be deducted on the company's tax return.

4) Raising debt capital is less complicated because the company is not required to comply with state and federal securities laws and regulations.

5) principal and interest obligations are known amounts which can be forecasted and planned for.

Disadvantages of Debt Compared to Equity

1) Unlike equity, debt must at some point be repaid.

2) Interest is a fixed cost which raises the company's break-even point. High interest costs during difficult financial periods can increase the risk of insolvency.

3) Debt instruments often contain restrictions on the company's activities, preventing management from pursuing alternative financing options.

4) The larger a company's debt-equity ratio, the more risky the company is considered by lenders and investors.

B) what is the purpose of treasury shares

Answer:-

1) Treasury shares are the shares which are bought back by the issuing company, reducing the number of shares outstanding on the open market.

2) Treasury share do not pay any dividends and they do not have any voting rights.

3) Companies may use treasury stock to pay for an investment or acquisition of competing businesses.

4) These shares can also be reissued to existing shareholders to reduce dilution from incentive compensation plans.

C) Explain the benefits and downside of straight line method.

Advantages

1) The straight line method is the simplest method for calculating depreciation.

2) This method is suitable for small businesses.

3) This method is very useful for calculating the depreciation charge on the assets of lesser value like furniture and fixtures.

Disadvantages

1) In the final years of the asset’s life, it bears more repairs and maintenance charges as compared to the initials years.

2) there is no provision for the replacement of the asset.

3) The straight line depreciation method is not useful in case of the assets with the long life and more value.

C) Explain the benefits and downside of declining method

Advantages

1) This method is simple to use.

2) This depreciation method is acceptable for income tax purposes.

3) Under reducing balance, the greater amount of depreciation is provided in initial years and this is matched against the higher amount of revenue generated by the use of new asset in initial year.

Disadvantages

1) This method charges heavy amount of depreciation in earlier years.

2) it cannot reduce the book value of a fixed asset to zero if it is desired.

3) It requires high rate of depreciation on fixed assets.

D) financial leverage and its advantage and disadvantage

Answer :-

Finacial leverage :- Financial leverage is the use of debt to buy more assets. Leverage is employed to increase the return on equity.

Advantages :-

1) it is powerful access to capital.

2) finacial leverage is ideal for acquisitions, buyouts. Because of the additional cost and risks of bulking up on debt.

DISADVANTAGES :-

1) It is risky form of finance.

2) leveraged finance option is more costly.

3) and also leveraged finance is a complex option to choose.

Thank you.