Question

Some people talk about the use of Debt as a source of financing as if it were evil and should be avoided at all costs. Does this make sense to you? Under what conditions does it make sense for a business to use Debt Capital (in lieu of Equity Capital)?

What are the implications for a company's Weighted Average Cost of Capital and Minimum Required Free Cash Flow Return on Assets if the company only uses Equity Capital to finance its Total Assets?

The majority of business owners the Instructor has met do not use any long-term financial planning process for their company. What would you say are the pros and cons of developing and using long-term financial plans for a company?

Answer 1

Debt financing is capital acquired through the borrowing of funds to be repaid at a later date. Common types of debt are loans and credit. The benefit of debt financing is that it allows a business to leverage a small amount of money into a much larger sum, enabling more rapid growth than might otherwise be possible.

In addition, payments on debt are generally tax-deductible. The downside of debt financing is that lenders require the payment of interest, meaning the total amount repaid exceeds the initial sum. Also, payments on debt must be made regardless of business revenue. For smaller or newer businesses, this can be especially dangerous.

Conditions that make sense for business to use debt capital:

1. How soon do you need financing?

If you need cash as soon as possible, then debt financing is the way to go. You can get business loans incredibly fast -- in a matter of hours even, if you apply to the right lenders. Meanwhile, equity financing involves finding the right investors, pitching your business, drawing up the legal documents and more.

2. How much capital do you need?

If you don’t need a lot, or you’re only looking for a small amount, then debt financing is the better choice. Equity financing rarely comes in small amounts, but you could get business loans for as little as $10,000 or less.

3. Do you mind sharing your business?

Some entrepreneurs prefer to keep their businesses to themselves -- and that’s okay. If you don’t want to lose control over how your business operates, then equity financing isn’t the way to go. If you’d welcome the experience and expertise of an investor, or if you’re more concerned with funds than ownership, then either path could work.

What are the implications for a company's Weighted Average Cost of Capital and Minimum Required Free Cash Flow Return on Assets if the company only uses Equity Capital to finance its Total Assets?

Ans: The weighted average cost of capital (WACC) measures the total cost of capital to a firm. Assuming that the cost of debt is not equal to the cost of equity capital, the WACC is altered by a change in capital structure. The cost of equity is typically higher than the cost of debt, so increasing equity financing usually increases WACC.

Equity financing – raising money by selling new shares of stock – has no impact on a firm's profitability, but it can dilute existing shareholders' holdings because the company's net income is divided among a larger number of shares. When a company raises funds through equity financing, there is a positive item in the cash flows from financing activities section and an increase of common stock at par value on the balance sheet.

The majority of business owners the Instructor has met do not use any long-term financial planning process for their company. What would you say are the pros and cons of developing and using long-term financial plans for a company?

Ans: According to me the pros and cons are:

Pros:

1. Better management
2. Anticipate cash needs in advance
3. Take needed cash flow steps – investment, loans, whatever – with enough anticipation to be effective.
4. Lay out expectations, milestones, and metrics for tracking progress
5. Develop an early warning system for unexpected changes
6. Catch unexpected changes early so you can manage the needed changes
7. Understand the flow of money in the business
8. Improve relations with investors, bankers, other third parties that affect your financial health
9. Sleep better having a better understanding of how the money is moving in and out of the business
10. Know your financial health at all times by comparing your plan to your actual results.

Cons:

There are no cons to a financial plan done right. It's only doing it wrong that produces cons. Taking too much time on it, not understanding uncertainty, expecting a higher-than-possible degree of accuracy. Not understanding its role in management.

Planning is about setting steps, milestones, and metrics, for management.

Planning is a matter of moving towards the horizon in an organized way, taking time to learn from the difference between plan and actual, and improving in steps.

A plan is not a constraint. People think – wrongly – that because you have a plan you have to stick to it, which is not the case. Setting expectations down and connecting dots becomes a dashboard, to help manage change. What was different and how does that affect everything else? There is no virtue in sticking to a plan just because it's there.