In: Accounting
What are the trade-offs in financing a company by owner versus nonowner financing? If nonowner financing is less costly, why don’t we see companies financed entirely with borrowed money?
What are the trade-offs in financing a company by owner versus non owner financing?
Ans: To decide between owner financing or non owner financing, we have to look upon certain factors like life cycle of company. If the company is a start up then the company should rely more on equity capital than borrowed capital because the paying capacity of the company is very less.
Non-owned financing trade-off:
Tax benefits: interest paid on debt financing is deductible but cash flows to equity financing are generally not. The higher the marginal rate, the greater the benefits of debt. The countries with higher marginal tax rates like US should borrow more than the companies in countries with lower marginal tax rates.
Added discipline: borrowing money may force managers to think about the consequences of the investment decisions a little more carefully and reduce bad investments. But there should be separation between managers and shareholders.
If non owner financing is less costly, why don’t we see companies financed entirely with borrowed money?
Bankruptcy cost: the probability of going bankrupt in case of borrowed capital is more. Only the companies with more stable earning should borrow more. Once a company goes bankrupt it has to bear both direct cost and indirect cost.
Loss of flexibility: every time a company borrows money it losses future borrowing capacity. So if a company wants to have borrowed capital in future it has to hold back use less debt financing
Credit rating: borrowed financing affects the credit rating of the company.