Question

Discuss pros and cons of using debt financing versus equity financing. Support your answer with real world examples and/or theoretical framework from the assigned readings.

Also, discuss whether or not, all else equal, firms with relatively volatile sales are able to carry relatively high debt ratios.  Provide an example of a company with relatively volatile sales.

Answer 1

Pros of debt financing:

1. Debt financing has a relatively lost cost of capital when compared to equity financing

2. Debt financing has interest payments. These interest payments are tax deductible and provide a tax shield

3. Debt is easier to obtain if you have a clean credit quality

Cons of debt financing

1. Increasing debt beyond a point increases financial distress costs

2. Increased debt increase risk and therefore equity investors would also like a higher return for the higher debt that the business takes

3. If your credit score is low, getting debt financing will be very difficult.

Real world example: Citrix, an American multinational software company has ZERO debt. A total cash and short term investments of $775 Million and total assets of 3.88 billion

Firms with relatively volatile sales will not be able to service very high debt ratios. It is because the volatility in sales will give some quarters with a higher profit which can be used to service the debt whereas in some quarters, there is not enough profit to service the debt. In such cases, the business may face more debt to pay the earlier debt which leads to vicious cycle and finally leads to closing down of the business. For example, the consumer goods company may have very good sales in the last quarter of the calendar year due to thanksgiving and Christmas whereas may have very less sales in the first quarter of the next calendar year.