Question

what are the advantages and disadvantages of Debt for corporation and for individual?

Answer 1

For Corporation:

ADVANTAGES:

Maintain Ownership

The main advantage of issuing bonds and borrowing money from lenders is that the complete ownership remains with the company. This is not the case with equity financing because stockholders have ownership rights in a company. The benefit of maintaining ownership is that management has complete control over the decisions made on behalf of the company. Management also has the ability to chose its own board members. The lenders just have the responsibility to return principal and pay timely interests.

Tax Benefits

Another advantage is that the interest paid on debt is tax deductible and this money can be used for furtherance of the business.

Greater Freedom

Businesses using debt financing to raise capital have more flexibility than those using equity financing because they are only obligated to the investor or lender for the repayment period. After all money is paid back, the business is completely free from its obligation. Companies also have greater flexibility because the paperwork to obtain debt financing is less complicated and less expensive than equity financing.

DISADVANTAGES:

Collateral

By providing collateral to the lender the business puts the business assets at potential risk. In case of default by the business the business assets collateralized can be sold off leading to further worsening of circumstances for the company.

Repayment

It is difficult for the companies with cash flow problems to make timely interests and principal repayments. If the company defaults the lenders can legally proceed against the company. This risk is not there in equity financing.

Credit Rating

Another disadvantage is that debt financing affects the credit rating of a business. A company that has a significantly greater amount of debt than equity financing is considered risky. A company with a lower credit rating that issues bonds typically will have to pay a higher interest rate to attract investors. Companies who have to pay more in interest may experience a cash flow problem in the future.

Bankruptcy

If the business is facing cash shortages then it may lead to business running into bankruptcy because if it has pledged assets to raise loan then any default would lead to selling of business assets and eventually may lead to bankruptcy.

For Individuals:

ADVANTAGES:

Low risk

It has a very low risk of default, so the lender is sure of getting timely interests and principal repayments.

Fixed payment

There is no fluctuation in the interest which the lender gets, so the lender can plan its expenditures with very surety relying on the interest.

Priority

The debtholders are on the top priority in the event of winding up or merger or acquisition of the company. They seldom lose their money.

DISADVANTAGES:

No participation in ownership

The debtholders are just lenders and not the owners of the company. They can’t contribute to any important decisions of the company. They have no voting rights in the company.

No residual interest

Sometimes companies have very high profits but the debtholders just get their fixed interest. It doesn’t matter to them whether the company is having high profits or not. The residual interest lies with the equity holders.