Question

In: Economics

Businesses can borrow from banks or by issuing short-term or long-term debt on the open market....

Businesses can borrow from banks or by issuing short-term or long-term debt on the open market. Why do they prefer to finance themselves with retained earnings rather than issuing debt? If they are issuing debt, when and why would a corporation prefer to borrow by issuing short term vs long term?

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Expert Solution

Answer : Retianed earning is a part of profit which are left over to meet the future requirement of the business. It means utilising your profit for the expansion of the business. The business has been used retianed earning as source of finance because :

  • Using retianed earning have no cost to the company.
  • If we used the debts than there is issue related cost but in case of retianed earning it is zero.
  • Using retianed earning cannot affect the ownership of the business. Existing shareholders are only the owners.
  • Less legal formalities in retianed earnings as compare to issuing debt . It is just required resolution passed in annual general meeting.
  • Cheaper source of finance as there is no cost incurred.
  • Retianed earnings strengthen the financial position of the company and appericate the value of the share where as debt means increasing in loan amount payable.

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When the company need finance for paying the expenses or expansion of the business than they can used different source of finance. One source of finance is issuing debentures. There are two types of debt such as :

  • Short term debt is to be paid off within 12 months.
  • Long term debt is to be paid after 12 months or it may to 2-5 years.

It depend upon the need of the business which long term or short term fund has been raised from the market :

  • Payment of payroll
  • Meeting extra production cost
  • Unexpected cash flow issues
  • Purchasing raw material in bulk.
  • Property Taxes

Long term debt has been raised by the business such as :

  • Expansion of the business
  • Lease and mortgage
  • Loan for purchasing costly equipment.

Example of Long term debt :

  • Bonds
  • Lease obligation
  • Contingent Liabilities

CRUX : It is directly depend upon business requirement which funds should be raised.

Rahul Sunny answered 2 years ago
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