THE CAPITAL STRUCTURE DECISION

The capital structure decision

The capital structure decision

1. What are the advantages and disadvantages of debt financing?

Debt financing represents any type of borrowing with a guarantee to reimburse the borrowed sum over a particular period of time in addition to interest payments. Accordingly, a company will take out a loan in some type from a lending institution and then the company can use the money on loan for any principle required by the company, and in response the lender will expect the debtor to make the payments along with the interest in a particular period of time.

The primary advantage of debt financing is that it allows the founders to retain ownership and control of the company. In contrast to equity financing, the entrepreneurs are able to make key strategic decisions and also to keep and reinvest more company profits. Another advantage of debt financing is that it provides small business owners with a greater degree of financial freedom than equity financing. Debt obligations are limited to the loan repayment period, after which the lender has no further claim on the business, whereas equity investors' claim does not end until their stock is sold. Furthermore, a debt that is paid on time can enhance a small business's credit rating and make it easier to obtain various types of financing in the future. Debt financing is also easy to administer, as it generally lacks the complex reporting requirements that accompany some forms of equity financing. Finally, debt financing tends to be less expensive for small businesses over the long term, though more expensive over the short term, than equity financing.

The main disadvantage of debt financing is that it requires a small business to make regular monthly payments of principal and interest. Very young companies often experience shortages in cash flow that may make such regular payments difficult. Most lenders provide severe penalties for late or missed payments, which may include charging late fees, taking possession of collateral, or calling the loan due early. Failure to make payments on a loan, even temporarily, can adversely affect a small business's credit rating and its ability to obtain future financing. Another disadvantage associated with debt financing is that its availability is often limited to established businesses. Since lenders primarily seek security for their funds, it can be difficult for unproven businesses to obtain loans. Finally, the amount of money small businesses may be able to obtain via debt financing is likely to be limited, so they may need to use other sources of financing as well.

2. How does the use of debt financing affect the rate of return that shareholders require on their investment in the firm's shares?

The use of debt financing essentially increases a shareholder's required rate of return. This has to do with the fact that debt holders tend to have a higher priority when its come receiving interest/principal repayments (If debt holders are not paid regularly, they can force the company into bankruptcy procedures) compared to shareholders and ...