Question

1. Why do firms issue debt instead of only issuing equity?

2. Why do firms focus on capital structure?

3. What do you think of a high profit firm like Microsoft with over 200 billion of cash and marketable securities on its balance sheet, would issue debt?

Answer 1

Generally, there are three reasons why firms issue debt instead of only issuing equity:-

a. Restrict the ownership be diluted

b. Interest acts as a taxshield

c. Return on equity gets increased

Lets discuss all the above reasons one by one.

a.The firms issue equity once they need to raise fund. Issuing equity means dilution of ownership of a firm. For example, before issuing an equity, 100% control is entitled to the firm itself, but after issuing an equity, the ownership is distributed to different shareholders who have the rights to vote on the decision taken by the firms. There is a possibility that company may loose control (< 50%) if continously diluted ownership to raise fund. That is why, firms issue debt to raise fund.

b. Once firms raise debt, they need to pay interest. Because of this interest expense, the firms need to pay less taxes. Lets try to understand this by the below example:

PARTICULARS	Rs.	Particulars	Rs.
Total Revenue	60000	Total Revenue	60000
Total Expenses	40000	Total Expenses	40000
Profir Before Tax	20000	Gross Profit	20000
Tax (@30%)	6000	Interest Expense	5000
Profit After tax	14000	Profit Before Tax	15000
		Tax @ 30%	4500
		Profit After Tax & Interest	10500

First Case: Firm is paying Rs.6000 as a tax, since the firm has no debt

Second Case: Firm is paying Rs. 4500 as a tax, since the firm has issued debt.Thus interest acts as a Taxshield.

c. Return on Equity is a vey important parameter for shareholers. Return on equity means how much a firm is generating profits from its Shareholder's investment in the firm. It is a Profitability measurement ratio. Lets try to understand this by the following example:

Particulars	Rs.	Particulars	Rs.
Total Net Income	2000	Total Net Income	2000
Equity	1000	Equity	500
Debt	0	Debt	500
Return on Equity	2000/1000= 200 %	Net income after Payment of Debt	2000-500= 1500
		Return on Equity	1500/500= 300%

First Case: The firm has no debt. So the entire capital has been rasied from equity (Rs. 1000). Therefore the return on equity is 200%

Second Case: The firm has issued Equity of Rs.500 and debt of Rs.500. Therefore, Return on Equity is 300%

Therefore, in the second case the firm is performing well in compare to the first case.