Question

Arab Potash Company is a Potash producer company that traditionally has not used debt to finance its projects. Over the last 10 years, it has also reported high returns on its projects and growth, and made substantial research and development expenses over the time period. The minerals industry overall is growing slower now, and the projects that the firm is considering have lower expected returns.

a- How would you justify the firm’s policy of not using debt?

b- Do you think the policy should be changed now? Why and Why not?

Answer 1

(a)- How would you justify the firm’s policy of not using debt?

The policy followed by the company is not justifiable because of the following reasons:

• A loan does not provide an ownership stake and, so, does not cause dilution to the owners’ equity position in the business.
• Debt can be a less expensive source of growth capital if the Company is growing at a high rate.
• Leveraging the business using debt is a way consistently to build equity value for shareholders as the debt principal is repaid.
• Interest on debt is a deductible business expenses for tax purposes, making it an even more cost-effective form of financing.   
• Debt can be somewhat less complicated to arrange than equity financing

It is given that over the past 10 years, the company has reported high returns on its projects and growth. Since the company was growing at a higher rate for the past 10 years, it could have used debt financing and could have earned much more return.

(b) Do you think the policy should be changed now? Why and Why not?

When the company is expected to perform well for the foreseeable future , you can usually obtain debt financing at a lower effective cost. However, if a company fails to generate enough cash, the fixed-cost nature of debt can prove too burdensome.

In the given case minerals industry overall is growing slower now, and the projects that the firm is considering have lower expected returns. Companies are never totally certain what their earnings will amount to in the future. The more uncertain their future earnings, the more risk is presented. Therefore in the current situation it is not good for the company to raise funds through debt because if the company fails to generate enough cash, the fixed-cost nature of debt can prove too burdensome