If the cost of debt is less than the cost of equity, should the firm use only debt for entire financing? Discuss
Answers
Answer:
If debt costs are lesser than the cost of equity, debts financing can be preferred.
Explanation:
It is mainly dependent on the company's perspective
If the business is in a tough position with lower sales, debt financing can be procrastinated.
debt financing is preferred If the promoter does not lose his stake in the firm.
The firm should be benefited by using both debt and equity at the optimum level
If a firm takes too much debt, the financers will increase the cost of the debt due to higher levels of debt in the firm.
Usually, the reason of cheaper rate of debt than equity is tax-deductible interest rate imply on Debt as well as the expected return of lenders is much less than equity investors.
In debt, The risk and potential returns are less.
But there are also some limitations on Debt.
So, you have to analyse these limitations first to check for the best option. for example,
=> produce distinct practical scenarios for the firm just like lower fund growth and margins in the problematic case.
=> do the "Stress test" of the firm and observe whether it can satisfy the need of necessary credit stats, proportion, and other requirements in the problematic case..
=> or, try substitute Debt structures and observe whether They work or not.
=> or, think about Equity for a few or all of the firm's financing requirements.
for instance,
Suppose, The Railway company needs to raise 15 billion of dollars for the new rail line. For that, the options are,
=> extra Equity revenue (show 43% of its current Market capitalization).
=> Term Loans , suppose For 10- year maturities, defrayment = 5 %, interest rate = 4%, Debt sweep = 50%, and maintenance agreements.
=> Subordinated Notes ( approx. 10-year maturities, no defrayment, interest rates = 8%, no primitive compensation , and DSCR agreement)
Lets analyse first with the Term Loans (as they're the cheapest).
surprisingly in the Base Case scenario, almost it's not possible for the firm to follow with the lowest DSCR agreement, and it seems not so good in the Downside or problematic cases.
Next, suppose we go with Subordinated Notes then it will be easier for the firm to follow with the DSCR because of lack of basic repayments. Eventhough, The DSCR numbers looks better, still issues occurs in the Downside and Extreme Downside cases.
So, we can try some Equity too.. We can start with twenty five to fifty percent Equity, which we can imitation by setting the EBITDA margins for Debt. but still problems arise in Year 4.
So, If the company has severe high EBITDA margins, lower fund gain, and constant cash flows than it's an ideal candidate for Debt.