Question

Why do firms borrow capital that has to be repaid with interest rather than finance a firm with 100% equity?

Answer 1

Compared to the cost of equity, the cost of debt is lower. Interest on debt is a tax deductible expense, and the firm can enjoy the tax shield of interest, which translates into an ever lower after tax cost of debt. Dividends paid to shareholders are not tax deductible.

Secondly, using debt in the capital struture keeps the equity base smaller, and therefore result in a higher earnings per share( EPS). A higher EPS results in higher market price of the stock, resulting in acheiving the ultimate goal of financial management, i.e. shareholder wealth maximization.

When the economy is stable, higher debt leads to higher sales, and higher profits, resulting in a greater Return on Equity. If a firm was 100 % financed with equity, the denominator would be larger, resulting in a lower ROE with the same amount of profit.

Loss of control is another disadvantage of 100 % equity financing. For additional funds, the company has to take in new investors, which leads to dilution of control. Financing the firmly partly with debt does not pose this disadvantage.