Question

For which of the following firms is debt financing most appropriate?

a biotech company whose breakthrough drug will not be approved for the next 10 years

a small oil and gas exploration company facing trouble due to falling gas prices

Silicon Valley tech startup with no revenue

a large, mature industrial conglomerate

Answer 1

Out of the above listed firms, a large, mature industrial conglomerate firm will be most appropriate for debt financing.

The reason behind selecting this kind of firm is that this type of firm already has a strong market reputation along with good corporate governance mechanisms and sounded financial disclosure policies that ensures transparency in their financial reporting. A large, mature industrial conglomerate firm always try to safeguard the interests of its all stakeholders and always try to maximise shareholders wealth.

Another important fact about his type of firms are they already have a foreseeable future. They know how much debt will be worthwhile for its business activities and to what extent the firm can be leveraged. If, the firm becomes over leveraged, then lot of problems arises. The first drawback may occur in increase cost of borrowing debt which can negatively impact the firm’s profitability. Then comes another important scenario i.e. if the firm suppose faces liquidity crisis, then the debtors or the lenders may feel reluctant to finance more debt in the firm which may create a huge problem at that time for the firm.

Now, coming to the reasons for others firms for rejecting them for debt financing are:-

· a biotech company whose breakthrough drug will not be approved for the next 10 years – In this case the return will be very long, say a decade, so the cost of debt may be very high. Also, there are lot of market risks associated with this kinds of debt because the time of debt is very long period and who has seen its future return.

· a small oil and gas exploration company facing trouble due to falling gas prices – Financing this type of firm with debt can be also costly because too much market risks in already associated with this type of firm. For example, the unprecedented crisis for COVID-19 resulted the prices of crude oil to go to negative territory.

· Silicon Valley tech start-up with no revenue – this firm has no revenue, therefore it does not have a foreseeable future. Also, who knows about this type of start-up company will be successful or not in future in carrying out its business related activities.