Question

Question 4.

While many economies were shut down during the pandemic, most firms suffer while a small number of these firms might extinct forever. On the other hand, some firms in selected industries actually thrived during this economic environment.

Boeing, which had been going through a crisis of its own with its 737 Max even before the pandemic, reported a US641 million loss for the first quarter of this year. Around the same time, Boeing borrowed an addition US$25 BILLION of new debt.

Apple Computers also borrowed US$8 billion of new debt in May 2020. For 2019, Apple’s net income was US$55 billion, has operating cash flow of US$69 billion, has cash and equivalent of US$66 billion and total asset of US$339 billion at year end.

(1) List and explain the benefits that firms could achieve from use of debt financing. (X marks)

(2) List and discuss some potential costs of using debt financing. (X marks)

(3) Apple Computers is a very successful firm despite the pandemic. Why would Apple want to borrow money at this time? Would borrowing money at this time indicate a sign of weakness to the investing community?

Answer 1

1. Benefits of debt financing:

• Retention of ownership: Debt holders are not the owners of the company. They are the creditors of the company. They do have have voting rights. Therefore they do not interfere in the working of the organisation. They do not dilute the ownership structure. All they need is the timely interest payment and repayment of principal amount on maturity. There is no loss of control or ownership to the shareholders or the company.
• Tax deductible expense: Interest paid on debt is deducted from the Earning before interest and taxes after which tax is charged on the balance amount. Interest payment serve as a great tool for tax saving purposes. Deduction of interest expense lowers the net cost of debt servicing. Debt financing is one of the cheepest source of raising funds.
• The leverage effect: Using debt effectively can increase the the earnings for shareholders. Equity financing or employing the retained earnings are costly sources because of the opportunity cost involved in it. Therefore the firms use debt financing in high yielding projects, which will generate more profits for the shareholders. Thus using debt leaves more surplus cash with the company even after interest payment. This results in higher Earning per share for the shareholders.

2. Potential cost of using debt financing:

• Interest cost: There is a periodically mandatory interest payment on debt financing. Interest is to be paid in debt issue irrespective of the profit or loss suffered by the organisation.
• Floatation cost: Cost incurred in offering securities to the public. It involves registration fee, legal charges and underwriting fees.
• Bankruptcy cost: Cost associated with financial difficulty, taht the company might get into distress because of increased use of debt financing.
• Agency cost: Cost of conflict of interest between shareholders and debt holders. It is the cost of conflict of interest created by seperation of management from ownership. For example, managers want to invest in risky securities because it will give higher return for shareholders. Debt holders want safety of money therefore they do not want to invest in risky securities. Therefore cost resulting from these conflicts is known as Agency cost.

3. Apple computer may want to borrow money at this time for the purpose of expansion, for paying of his past debts, for reducing its tax obligations, for maintaining debt to equity ratio, for buy back of shares and so on.