Presentation to the Board of Directors, The Pros and Con of Debt Financing The c

Question

Presentation to the Board of Directors, The Pros and Con of Debt Financing

The calculation of after-tax cost of debt plays a role in managing capital costs. You have been asked to present a few matters related to Debt (Bond) financing to the Board of Directors.

Please briefly explain to the Board:

1) the usual collateral position of Bondholders (Lenders) versus Equity investors,

2) why common stockholders can demand a higher rate of return than lenders, and

3) why you would suggest debt (or equity) financing.

4. PLEASE LIST WEBSITES OR REFERENCES ON WHERE YOU GOT THIS INFORMATION

DO NOT COPY THIS AND PUT IT IN YOUR DISCUSSION AS I WILL SEE THIS!!!

Explanation / Answer

Usually, the equity holders do not have any collateral neither do bondholders have it. However, in case of the bondholders, the interest rate is fixed. The yield may differ as per the market price of the bond. However, a secured bond does have a collateral. Common stockholders do not demand a fixed interest on their capital and have put it on more risk than the bondholders. In a situation of liquidation, the bondholders receive their money as priority lenders but the equity holders get only what is left out. So for all the above-listed reasons, equity holders demand a higher rate of return than any other lenders. In case of debt financing, there are multiple reasons over equity The interest paid on Debt is subject to tax deduction. The debt will have a short-term impact on the company balance sheet whereas equity is going to stay forever. The cost of equity is more than cost of debt. However, debt financing carries an obligation of repayment whereas there is no such obligation in equity. The is no effect on Earnings per share in debt financing

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