Question

Answers should be substantive and include consideration of relevant accounting concepts.

What are the trade-offs in financing a company by owner versus non-owner financing? If non-owner financing is less costly, why don’t we see companies financed entirely with borrowed money?

Answer 1

The sources of finance for entities could be mainly catagorized to two parts. 1 ) Shareholders fund 2) External Borrowings.When the entity porcures finances from either sources it has to pay some additional amount of money besides the principle amount.The additional money paid to these finances is called the cost of capital.Capital structure is the combination of capitals from different sources of finances. While choosing a suitable financing pattern certain fundemental principles should be kept in mind like

1.Cost principle
According to this principle an ideal pattern or capital structure is a one that minimizes cost of capital and maximizes EPS.Debt capital is actually cheaper and interest is deductable for income tax purposes.

2.Risk principle

Based on this principle reliance is placed more on common equity than on debt.Use of more debt means higher commitment in the form of interest.This would lead to erosion of shareholders value in an unfavourable business situation.There are 2 risk associated with this principle i)Business risk - Unavoidable risk because of the environment in which the firm has to operate and it is represented by the variability of Earnings Before Interest and Tax. ii)Financial risk. - It is the risk associated with availability of EPS caused by the use of financial leverage.

3.Cost control principle

Issue of new equity will dilute existing control pattern and also involve higher cost.Issue of more debt causes no dilution in control but causes a higher degree of financial risk

4.Flexibility principle

By flexibility it means that the management chooses such a combination of source of finance which it finds easier to adjust according to the changes in the needs of fund in the future too.

5.Besides other principle factors such as nature of industries competition in the industry etc should also be considered

Therefore a suitable pattern of capital structure must bring about satisfactory compromise between the above principle.Since cost of debt is cheaper firm prefers to borrow rather than to raise from equity. As long as return on investment more than cost of borrowing, extra borrowings increases the EPS.However beyond the limit it increases the risk and share price may fall becaue shareholders may assume that their investment is associated with more risk.

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