Question

i. With your understanding of lessons on capital structure, which four (4) factors should your firm(FMCG) consider before choosing any source of debt finance?

ii. Discuss four (4) risks that your company(FMCG) is likely to be exposed to if it goes ahead with this source of debt finance.

iii. Explain how this decision will affect the return to the equity holders or shareholders of your company following the arguments of M&M proposition 2.

Answer 1

Factors to be consider before choosing any sorce of debt finance

i)Cost of Fund:It is the most important and decision influencing factor.Cost of the fund is the amount the firm has to pay against the amount borrowed periodically.It affects your net income and consequently the cash flows of the firm.Higher the cost of fund, lower the net income and cash inflows.

ii)Redemption duration:It is the period within which debt has to be paid off in full.In case of project with longer duration,debt with longer duration is suitable.If the money is required for short period of tiime,it is best to use short term source of debt such as bank overdraft.

iii)The amount required:Some source of debt are ill suited for raising large amount of money such as bank overdraft as it has a limit as to how much can be withdrawan.

iv)Collateral Security:If the business is large and has collateral security which it can use to borrow then it can consider debt from financial institutions.In other case it can issue bonds to public for raising debt.