Question

Mrs. Jay has asked you, the CFO of the company, to write a memo outlining the advantages and disadvantages of using debt relative to equity. She also wants the memo to cover the impact that his decision might have on the firm’s weighted cost of capital and overall firm value.

Answer 1

Advantages :

• Raising debt does not involve losing control of the company, unlike equity, since equity shares carry voting rights
• Issuing debt is less cumbersome than equity, since issuing equity is subject to much more regulatory oversight than issuing debt
• Cost of debt is cheaper than cost of equity. That is, the required return for debt investors is usually lower than the required return for equity investors
• Interest payments are a tax-deductible expense, whereas dividend payments are not

Disadvantages :

• Debt involves mandatory fixed periodic payment of interest, unlike equity where the payment of dividend and the rate of dividend is at the discretion of the board of directors
• Debt involves a fixed interest expense every period, which puts pressure on the cash flows of the company since the debt has to be serviced irrespective of profitability

The cost of debt is usually cheaper than equity. That is, the required return for debt investors is usually lower than the required return for equity investors. Hence, issuing debt can lower the overall cost of capital, and thereby increase firm value.