Question

When a company assumes that there might be an economic downturn, it reduces the debt of the project.…”Assuming that this is a new project and cash positive cash flows are sparse, is it then a good idea to reduce debt? How would this impact future considerations when additional cash might be needed?

Answer 1

When a company assumes that there might be an economic downturn, it reduces the debt of the project.…”Assuming that this is a new project and cash positive cash flows are sparse, is it then a good idea to reduce debt?

Solution:

The economic downturn leads to lower positive cash inflows, indicating that debt financing may not be an appropriate source of financing. Economic slow-down causes projects to earn lower cash inflows as a result of less disposable income in the hands of the citizens. Debt financing puts a fixed burden on the firm in times of sparse inflows, given its fixed cost nature. This can be explained with the help of an example:

Normal Economic Conditions

Cash Inflows=200000

Interest on debt=5000

Earnings before tax= 200000-5000

=195000

Economic Downturn

Cash Inflows=100000

Interest on debt=5000

Earnings before tax= 100000-5000

=95000

The reduction in earning has a direct impact on the earnings of the shareholders/company due to presence of fixed charges on capital.

It is advisable to reduce or rather shift the debt financing to equity financing, thereby reducing the fixed burden on the earnings of the firm.

How would this impact future considerations when additional cash might be needed?

Solution:

Future considerations for fulfilling additional cash requirements would include:

a) Careful analysis of future economic conditions: This involves understanding whether the economic condition would lead to a recession or boom period. The recession period should involve less use of debt financing and more use of equity financing. and vice versa for boom periods.

b) Cost of Capital: This includes careful weighing the repercussions of obtaining a fixed cost capital in times of boom period. As business cycle follows its path which leads to the advent of recession after the boom period, the fixed liability should be such that even in the presence of sparse positive cash inflows, these fixed obligations could be met, without bothering the liquidity position of the firm.