Question

Discuss pros and cons of debt financing in contrast to equity financing in capital budgeting. What are the implications of each for shareholders’ wealth maximization?

Answer 1

Debt financing means fixed financial commitment in the form of interest payment and repayment of debt after a fixed period of time. But interest expense is considered as tax deducted expense which results in interest tax shield and which reduces the cost of debt and cost of debt is also considered lower in comparison to cost of debt but debt financing results in fixed financial commitment whether business has earned profit or loss.

On the other equity financing does not involve any kind of tax savings and would results in higher cost of equity financing due to no tax savings and high level of risk. But on the other hand use of equity financing results in dilution of control. but it results in higher profit margin available to equity investor.

Use of debt will decrease the cost of debt which would results in more profit and increase in wealth of shareholders while use of equity would results in more cost of capital which will reduce the shareholders wealth