Question

What are the pros and cons of increasing debt in a firm's capital structure? according to the recent survey of CFO's conducted by Duke University. What are two of the most important factors that American CFO's consider when deciding on the appropriate level of debt?

https://faculty.fuqua.duke.edu/~charvey/Research/Published_Papers/P76_How_do_CFOs.pdf

Answer 1

The increasing the debt content in the capital structure will provide a company with temporary capital to finance its projects at a fixed expense called interest. The pros and cons of increasing debt in a firm’s capital structure are:

PROS:

1) The debt is a temporary capital and it is whipped out of capital structure as soon as projects ends.

2) The fresh shares are not issued which keeps the EPS intact.

CONS:

A) It carries a fixed expense at a higher rate, below or above the Return on Capital.

B) Being compulsory to pay principle and interest yearly, so provide pressure on the yearly cash flows.

The American CFO’S must consider following factors while deciding the appropriate level of debt :

a) Return on Capital and Cost of Debt: The cost of debt should be lower to the Return on capital, otherwise it will vanishes the Return to shareholders.

b) Limited Use of debt : The debt should be used to fill the gap of projects financing and squared up as soon as the projects ends. Any permanent use of the debt will force the company to replace it through the issue of common shares which dilutes the EPS and return to shareholders.