Question

In structuring the capitalization of a corporation, what are the advantages and disadvantages of utilizing debt rather than equity?

Answer 1

Capital structure refers to the mix of sources from where the longterm funds required in a business may be raised.It may be in the proportion of Debt,Preference capital and Equity capital. It is the optimum when the firm has a combination of equity and debt so that the wealth of the firm is maximum .

The advantages of utlilizing debt rather than equity are as follows:

• Raising debts are less complicated as compared to equity,as the company is not to compy with the state and federal laws & regulations.
• Interest on the debt can be deducted on the company's tax return,lowering the value of actual cost to the company, its gives the tax shield benefit.
• The ownership of the company stays with the management ,the debt financers has no control over the economic decisions of the company .
• The loan and interest amount can be calculated and forcasted and planned for,where as the market price of equity cannot be forcasted .
• More cash in hand is available .
• The debt doesnot have a equity share in the company ,so it doesnot dillute the owner's interest in the ownership's fund of the company.

The disadvantages utilizing debt rather than equity are as follows:

• Debt must be repaid at some point of time ,unlike equity .
• Higher the debt-equity ratio , the more the risky company is considered by the lenders and investors.
• Interest is a fixed cost ,even if the company suffers a loss the company as to pay interest and principal amount.
• Debt financing generally needs collateral security.