Question

From the corporation’s perspective, a lower WACC will benefit the company because a lower discount rate would raise the firm value, and consequently stock value. This has a managerial implication on firm’s leverage decision. Explain why companies generally take advantage of debt financing.

Answer 1

Reasons for companies taking advantage  debt financing are the following:

1. No dilution in share holding

Equity financing involves participation in ownership, thereby diluting the promoters' ownership This may eventually lead to change of hands in ownership and control. On the other hand, debt financing does not involve share in equity and ownership. The obligation will cease on repayment of the debt along with interest as decided at the time of entering the agreement.

2. Tax benefits: Interest paid is an allowable expenditure for tax purposes, in most of the counties. Hence debt financing will help in reducing the tax burden. This benefit is not available in equity financing. As a result, post tax weighted average cost of capital (WACC) will be less, in case the proportion of debt in the total capital structure is high.

3. Cost of debt is often less than the cost of equity which will be the shareholders expectation of yield