Question

What are the benefits and detriments of using debt as a source of funds when compared to issuing common stock?

Answer 1

Benefits of debt as source of funds:

1)      Debt capital increases leverage of the firm and therefore enhances the equity capital return

2)      Debt capital is generally cheaper than sourcing equity capital

3)      Finding debt capital is quite easier than finding private equity investors, there are lot of financial institutions or banks who can easily finance the debt of an entity

4)      Raising debt is less time consuming than equity

5)      Debt capital issuance protects the interest of existing equity of the firm because equity holders’ rights are not diluted

Detriments of issuing debt or sourcing funds through debt:

1)      Replacement of debt at time maturity or payment of existing debt can be troublesome in illiquid market situation

2)      Debt cost can be very high at time of roll-over or replacement of existing debt

3)      As debt capital increases leverage of the firm and same time it hampers the additional borrowing ability of the firm

4)      Highly debt-based entities are not considered as good by rating agencies and financial institutions and it detriments the borrowing ability of the entity