Question

• Explain why a firm would use debt in its capital structure?
• What are the advantages and disadvantages?
• What types of firms would tend to have high costs of capital? What types would have low costs of capital? Why?

Answer 1

There are many benefits for using debt over equity

a) debt component provides tax benefit to the company. Equity doesnt provide such opportunity

b) cost of raising debt is less than equity. The amount of money raised through IPO is very high in terms of fee paid to investment banks and other agencies

c) Equity lender will have claim on company. Where as debt lender will not tell how to run a company.

d) Equity provider will have full claim on profits. In debt, you pay only interest and principal.

Companies which are capital intensive will use high cost of capital. If a construction firm wants to raise debt then intial debt component may be cheaper but the more debt, the cost would be high. Companies where capital expenditure is high they will have high cost. Companies like IT will have low capex and hence less cost of capital

Major disadvantages of debt is you will have liability which has to be paid no matter whether you make profit or loss. Penalities lead to lowering of credit rating to company.