Question

A) If the cost of debt is typically significantly less than the cost of equity (especially on an after-tax basis), what do you think about the idea of capitalizing (or funding) a business entirely with debt? Explain your reasoning in 200-500 words.

B) If you were a venture capitalist considering providing funding to a cash-constrained firm, what criteria could you use to assess the accuracy of their cash flow forecasts and the adequacy of their requested cash injection? Explain in 200-500 words.

Answer 1

Ans A: When the cost of debt is significantly lower than the cost of equity than It is always wise that one should use the maximum of debt in his capital structure. But at the same time, we should not forget that using debt as the only source in the capital will also lead to another danger that is the payment of interest on the debt taken.

Interest is always an expense item and it will deteriorate the profit further for low profit making company & for new startups, and this will downgrade the business value in open market.

Hence, It is always advisable that one should strike a balance between debt & equity while drawing the capital structure.

Since here in this case cost of debt is quite lower as compare to equity, it is advisable to use more of debt, but entire capital should not be funded by only debt since it brings some drawback with itself. Hence the ideal situation would be to fund the capital by debt in the range of 60% to 75% and other the rest should be funded by equity. So that a proper and healthy capital structure can be drawn upon.