Question

Why do many companies prefer to use debt to provide capital for their operations?

Answer 1

Capital can be provided to the operations of business in the form of either equity or either debt. The companies may use either of the option to fund its business using equity capital or using debt. It may structure the ratio of the extent of equity and debt to maintain its optimum cost of capital.

The reason why companies prefer to use debt to provide capital for their business operations can be explained by analyzing the disadvantages of raising equity capital than that of debt, following are some of them :

1. Dividend is payable on equity share capital outstanding which is not fixed and is variable depending upon the profits of the company, since dividend is the share of profit to be distributed among the equity share holders.
2. Debt on the other hand accrues fixed interest payable on the usage of debt over the period of time and does not depend on the variability of profit of the company.
3. Dividend paid on the equity share capital shall affect the market price of the share of the company while the interest paid on debt does not affect the share price.
4. Issuance of equity share capital is a cumbersome task and require many kinds of approval and compliance from the exchange and the securities regulator, while the raising of debt is a easy task than that of raising equity.
5. Tax benefits are available on the interest paid on debt since interest is deductible on arriving the before tax profit of the company, while no tax benefits are available on dividend paid on equity since it is the appropriation of after tax profit of the company only.
6. Raising of equity share capital shall increase the number of shareholders of the company and hence the number to owners shall also increase, whether the raising of debt shall only create charge on the assets of the company (if debt is secured) but no increase in the owners.

Hence from the above points we can conclude that companies would prefer to use debt to provide capital for their business operations.