The Capital Structure Decision and the Cost of Capital-FINMOD4case

The Capital Structure Decision and the Cost of Capital-FINMOD4case

Advantages and Disadvantages of debt financing

Debt financing basically means undertaking debt obligations from an institution which may in most cases be a financial institution like banks or developmental financing institutions . Borrowing from a bank or other financial institution has several advantages including tax deduction benefits , not parting with ownership of the company and earning higher return on assets and equity . On the negative side , debt obligations can result in disadvantages as well including positive and negative covenants imposed on companies in

to take a loan . Other disadvantages include having enough cash flows to pay back debt and interest obligations , having a markup rate assigned to the loan indicative of a regular interest being accrued and payment of the same to the financial institution from which the loan has been taken , and having collateral to secure the debt obligations to be taken . In such cases , a company may want loans to be taken from the directors in to eliminate the interest rate factor assigned in case of loan taken from a bank . In the case of equity financing , the company will not have to keep security or collateral against the loan taken , nor would it have to necessarily make debt payments (Debt vs . Equity Financing

Consider a firm that needs 8 ,000 in assets . It can be financed in one of two ways

It could be 100 equity , or 50 equity and 50 debt . If it sells stocks they will sell for 20 per share . They could also borrow at 10 . If they invest , the state of nature will determine the ROA

All Equity Structure

Number of shares 400

Debt 0

Interest payments 0

State of Nature Recession Normal Boom Breakeven

ROA 5 15 25 10

EBIT 400 1 ,200 2 ,000 800

ROE 5 15 25 10

EPS 1 .00 3 .00 5 .00 2 .00

Leveraged Capital Structure Number of Shares 200

Interest payments 400

State of Nature Recession Normal Boom BE

ROA 5 15 25 10

EBIT 400 1 ,200 2 ,000 800

Interest Payments (400 (400 (400 (400

Net Earnings 0 800 1 ,600 400

ROE 0 20 40 10

EPS 0 4 .00 8 .00 2 .00

Now consider an investor with two plans . She has 2 ,000 of her own money

Plan One : She uses her 2 ,000 and buys 100 shares in the leveraged firm . At 20 per share that will give her 100 shares . What would be her return

State of Nature Recession Normal Boom

EPS 0 .00 4 .00 8 .00

Earnings from Stocks 0 .00 400 800

Plan Two : She borrows 2 ,000 for a bank at 10 , and she combines that with her own 2 ,000 for a shares in the Since she has 4 ,000 she will buy 200 shares . What are her earnings

State of Nature Recession Normal Boom

EPS 1 .00 3 .00 5 .00

Earnings from Stocks 200 600 1 ,000

Interest owed bank...