Question

Recently you have been invited to the board meeting where the main point on the agenda is to make the decision whether company should issue new stocks or write some new bonds to finance the outstanding project that is considered to be profitable in the future and has a strong support among board members. You need to explain and suggest to what extent should the firm use debt rather than equity financing?

Answer 1

As the question is to what extend the firm should use debt financing, I am assuming the board has already decided to raise bonds.

Debt financing has numerous advantages over equity financing such as the lendor has no control over our business, presence of tax shield etc. But there is always some threshold while taking debt financing over which it can be more costly than equity financing.

Well managed companies use debt such that they generates higher profit compared to interest expenses. If debt is too high interest paid will eats up the revenue. Leverage ratios help us understand the fine line between good debt and bad debt.

• Financial Leverage Ratio (Total Asset/ Total Equity) : •The financial leverage ratio gives us an indication, to what extent the assets are supported by equity. Ideal between 1.8-2.8

• Interest Coverage Ratio: (EBIT/Interest Payment) : Shows how much the company is earning related to the interest burden of the company. If the company has an interest burden of 500 dollars and an income of 2000 dollars, then we clearly know that the company has enough funds to service its debt.

These ratios indicate that there is an optimum amount of Debt that can be taken such that it will maximize the tax shield, minimize the WACC or cost of capital to company. (Refer the figure attached).