A company needs financing. The CFO is proposing that her company issues debt rather than equity,...

A company needs financing. The CFO is proposing that her company issues debt rather than equity, because interest rates are low and thus debt is clearly cheaper than equity. Do you think the CFO's reasoning is right & Why?

Expert Solution

When the interest rates are lower, then the debt capital will be cheaper but this is not the most requirement for the inclusion of debt capital in the overall capital structure of the company because debt capital will always be carrying a financial risk of financial distress as they will be having a fixed the payment of interest whether the company is making the profit or whether the company is making the loss, so these deb capital can put the company into a financial insolvency, if the company is not able to meet up with their debt capital repayment obligations.

so while inclusion of the debt capital into the total capital structure of company, it has to be seen that the interest tax deduction related with the debt capital is to be compared with the overall cost of financial distress related to the debt capital and balance should be maintained between the benefits and the cost of financial distress, so decision should be made afterwards in order of investment into overall debt capital.

Even if the interest rate is lower and the debt capital will be cheaper, then also at such time, when the revenue generation of the company is highly sceptical these debt capital carry a lot of financial distress risk, which can expose them to bankruptcy, if they are not able to made with payment of interest cost.

jeff jeffy answered 2 years ago

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