Question

Your contribution to the discussion requires 1-2 paragraphs, use of proper grammar, and citing of sources. Participation in the weekly discussion provides the opportunity to learn and apply new information in manageable amounts of timely contributions, and to receive useful feedback.

Referencing textbook readings, lecture material, and current business resources briefly explain pros and cons of using debt financing.

Also, discuss types of companies that should be carrying relatively lower levels of debt (list 3-4 descriptive aspects of these firms: their size, level of volatility in sales and free cash flow, predictability of this volatility, age of the firm etc. - any features you think are important). Provide an example of a firm (or entire sector)) which should use more debt and give an example of a firm (or entire sector) for which using less debt financing would be rational.

Answer 1

Debt financing happens when a firm raises money for working capital or capital expenditures by selling debt instruments to individuals and/or institutional investors. A firm sells fixed income products such as bonds, bills, or notes. Debt financing is the opposite of equity financing.There are many pros and cons for debt financing that need to be considered before taking any funds from an outside source. What is good for one business owner may not be such a good idea for another.

The Pros of Debt Financing

1.Maintain Ownership of Your Business: You retain the right to run your business however you choose without outside interference.Borrowing from a bank or other type of lender requires paying it back in the agreed upon timeframe,but they’re not going to get involved with how you run your day-to-day operations.

2.Tax Deductions:The principal and the interest payments on business loans are classified as business expenses which can be deducted from your business income taxes.In some ways, the government is your partner in your business with a percentage ownership stake (your tax rate)

3.Lower Interest Rates:Tax deductions can affect your overall tax rate. In many cases, there can be a tax advantage to taking on debt. For example, if the bank is charging you 10% for your loan and the government taxes you at 30%, there's an advantage to taking a loan you can deduct.

4.Acquisition Proceeds: There is no exit agreement to pay out a certain percentage to investors if the company is acquired. Instead, all proceeds go straight to the company and does not get split up among banks or lenders.

The Cons of Debt Financing

1.Repayment: Loans are strictly monitored and must be paid on time regardless of how your business may be petrforming financially.

2.High Interest Rates: Even after calculating the discounted interest rate from your tax deductions, you might still be faced with a high-interest rate because these will vary with macroeconomic conditions, your history with the banks, your business credit rating and your personal credit history.

3.Impacts on your credit rating: If your business relies too heavily on debt financing, it then it can affect your overall credit rating (making it more difficult to secure funds in future rounds).The more you borrow, the higher the risk becomes to the lender so you'll pay a higher interest rate on each subsequent loan.

4.Cash & Collateral: Banks and lenders may ask for collateral of equal value to the loan in case you default on your payments. If you find yourself without cash at the time of repayment you risk losing something important to you or your business

Types of companies that should be carrying relatively lower levels of debt

A tech company that delivers all of its products online and does not have to worry about storing physical products or maintaining a customer-facing physical space would require less debt financing.Firms in the technological industry to be more inclined to low or even zero debt capital structure External debt in the name of the business is often a problem, since many of these firms have few tangible assets that can be used as collateral (Colombo & Grilli, 2007).There is also a higher risk of failure for firms based on new technologies, which serves as added deterrent to bank lending (Guidici & Paleari, 2000). While some technology-based firms may be able to attract external equity in the form of angel investors and venture capital (Audretsch & Lehmann, 2004), this can be challenging as well, since it is difficult for investors to evaluate the demand for new technologies and products.The informational opacity of new technology firms makes it difficult for them to raise either external debt or external equity (Moore, 1994;Westhead & Storey, 1997; Guidici & Paleari, 2000). This observation is consistent with both the Pecking Order and the Life Cycle theories, both of which contend that firms will start out by relying on internally generated funds before gaining access to external sources. In the case of technology-based firms, reliance on internal sources may be intensified by higher levels of asymmetric information.

Financial economists have singled out three additional factors that limit the amount of debt financing: personal taxes, bankruptcy costs, and agency costs. Strebulaev and Yang (2013) point out towards factors like firm hierarchy structure and the effect of shareholders on firm decision making. Byoune, Moore and Xu (2012) point out that zero debt firms can still work because when they pay high dividends they get rid of the agency problem as pointed out by Jensen (1986).

Provide an example of a firm (or entire sector)) which should use more debt and give an example of a firm (or entire sector) for which using less debt financing would be rational.

Utility companies have a stable amount of income and demand for their services remains relatively constant regardless of overall economic conditions. Also, most public utilities operate as virtual monopolies in the regions where they do business. So, they do not have to worry about being cut out of the marketplace by a competitor. Such companies can carry larger amounts of debt with less genuine risk exposure than a business with revenues that are more subject to fluctuation in accord with the overall health of the economy.

Firms in the technological industry to be more inclined to low or even zero debt capital structure given the uncertainty over the future of a technology or an innovation.. Young firms in high-growth industries,wholesalers and service industries tend to use less debt.