A) Explain why debt is typically the cheapest source of financing for the firm a

Question

A)     Explain why debt is typically the cheapest source of financing for the firm and common stock the most expensive (hint – there are two reasons why debt is the cheapest…you should mention them both). Note that the word “Explain” is not the same as “list” – to get full credit

B)      Given the statement in A (debt is typically the cheapest source of financing for the firm and common stock the most expensive), firms that want to minimize their cost of capital should get 99% of their total financing from debt and only 1% from common stock. True or False and explain.

Explanation / Answer

A) Debt is typically the cheapest source of financing for the firm and common stock the most expensive :

1. Debt Have Fixed interest Charges and the Redemption price of the Debt is not driven by the market. On the other hand Equity is expensive since the EPS varries with the variation of Net Income.

2. Interest is allowed as deduction from Net Income, so the Company enjoys the tax benefit on interest paid.

This is only applicable for the Companies who are earning income. In case of company making loss the burden of Interest on debenture increases the loss further and make the Companies situation worser.

B) The Statement is False.

The Debt Equity Ratio can not be 99 : 1.

The ideal debt equity Ratio varies from 2:1 to 1.5 :1 depending upon they type of industry in which the Company belongs.

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