Some people talk about the use of Debt as a source of financing as if it were ev
ID: 2792241 • Letter: S
Question
Some people talk about the use of Debt as a source of financing as if it were evil and should be avoided at all costs. Does this make sense to you given the course material? Under what conditions does it make sense for a company to use Debt capital (in lieu of Equity capital)? Under what conditions does it not make sense to use Debt capital for a business? Some people talk about the use of Debt as a source of financing as if it were evil and should be avoided at all costs. Does this make sense to you given the course material? Under what conditions does it make sense for a company to use Debt capital (in lieu of Equity capital)? Under what conditions does it not make sense to use Debt capital for a business?Explanation / Answer
Cost of debt is usually lower than cost of equity. So, total WACC if it use debt capital is lower than cost of equity alone. Aim of company management is to maximize shareholder wealth by earning more profit for the shareholder. if WACC will be minimum then value of firm will be maximum. interest payment on debt capital is considered as expense for company, so company can deduct interest expense from taxable income. So becaus eof debt capital company need to pay lower tax.
More debt in company balance sheet is a signal of risk. Use of debt in captal structure is tradeoff between risk and lower cost of capital. So company wants to add debt in capital structure upto optimal level, so that overall cost of capital is minimum.
When company earns more than interest payment on debtcapital then add debt in capital structure is good for company. the excess return on debt capital from interest payment is goes toward equityholder return. So because of debt capital return on equity increase.
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