To the company, the advantages of having debt finance are:
1. Debt has a lower direct cost than equity finance, for two reasons: it is less risky to the investor, and interest, unlike dividends, is a tax-allowable expense.
2. Issue costs of debt are cheaper than equity shares, because there are no onerous prospectus requirements. Loans can normally be arranged more quickly than share
3. There is no dilution of ownership if debt is issued. This may be important if control of the company is at stake.
However, the directors of the company need to consider the fact that:
a. Introducing debt into the capital structure causes an increase in the cost of equity, because of financial risk.
b. Too much debt increases the risk of bankruptcy and can cause the company to incur significant costs in trying to avoid it, as well as increasing the costs of equity
c. Unlike equity, debt normally has to be repaid at the end of its term. This may cause problems if lenders are unwilling to renew the facility.
d. Assets of the company, or even personal assets of company directors, may need to be pledged as security for the loan. other restrictive covenants may be written
e. Interest rate risk. For example, the company has borrowed at floating rate and interest rates rise.
The lender can also benefit from debt finance. Some of the benefits are:
a. Debt finance earns the lender interest (and frequently other charges). This provides a steady stream of predictable income, even if the company’s profits are reduced, because interest must be paid before any dividends on shares are allowed.
b. It provides a business contact for the lender, which may allow the marketing of other services (for example, insurance, foreign exchange, etc.)
To the lender, the disadvantages are:
• The company may default on its interest or repayment
• There is no extra benefit if the company does well. Interest is not dependent on company profits.
• Interest rate risk, for example the risk of lending at fixed interest when interest rates rise, may be significant.
The shareholder can as well benefit from debt finance. Some of the benefits are:
A. The cheap cost of debt finance allows returns to shareholders to be increased. In particular, the expectations of tax relief on debt interest can cause an increase in the value of the shares (the ‘tax shield’).
B. Ownership is not diluted.
However, to the shareholders, the disadvantages of debt finance are:
• The existence of debt in the capital structure makes equity returns more volatile. This is known as financial risk and it causes a compensating increase in the required return of shareholders.
• Too much debt increases the risk of bankruptcy.