Question

Presentation to the Board of Directors, The Pros and Con of Debt Financing

The calculation of after-tax cost of debt plays a role in managing capital costs. You have been asked to present a few matters related to Debt (Bond) financing to the Board of Directors.

Please briefly explain to the Board 1) the usual collateral position of Bondholders (Lenders) versus Equity investors, 2) why common stockholders can demand a higher rate of return than lenders, and 3) why you would suggest debt (or equity) financing.

Answer 1

To, The Board of Directors,

Sub: Importance of Debt financing

The place of the debt under the capital structure is an important point from the angle of shareholders and the company at large because of

1. Lower cost of issue or raising the fund.
2. Non-permanent nature of debt.
3. Deduction for the taxation purpose.
4. Non-ownership character of the debt.
5. Effective lower cost than return on capital.

The infusion of the debt will leverage the return to the equity shareholders. The formula adopted by the companies to include the debt in the capital structure is that keep on infusion of debt in the capital structure till cost of debt is lower to the Return on Capital. Thus, debt increases the return to the equity shareholders without claiming ownership.

The Equity shareholders are the owners of the company, so they demand higher return on their contributed capital.

Being the favoring features of the debt will invite interest in the advocating for the debt financing.