Question

Some people talk about the use of debt as a source of financing as if it were evil and should be avoided at all costs. Under what conditions does it make sense for a company to use debt capital (in lieu of Equity capital)? Under what conditions does it not make sense to use Debt capital for a business?

Answer 1

Conditions which makes sense for a company to use debt capital in lieu of Equity capital are:
1.When a company has very low debt ratio or has no leverage at all. In that case the company can use debt to get the benefits of interest tax shield and to increase the value of firm. More over in that case cost of debt will be lower.
2. When the credit rating of company is very high. In that cost of debt will be lower than its peer and it will have lower cost of capital.
3. When the economy is predicted to boom and demand would be high. In such a scenario debt financing is better.

Conditions when debt capital doesnot make sense for a business are
1. When a company has very high leverage or debt ratio. In that case incremental cost of debt increases .
2. When credit rating of company is very low the cost of debt of the firm increases resulting in lower cost of capital.
3. When the economy is in recession then raising debt doesnot make sense as distress cost increases and there is higher chance of bankruptcy.