Disadvantages The preference of firms choosing debt to finance their expenditures is explained in details with reference to a practical example from Pakistan. But there are many varied reasons that present interesting findings that debt financing may not be the best source of finance. It has with in, attached several limitations and shortcomings. For starters, unlike equity, the money has to be paid back to the lender within a fixed amount of time. Also, the interest on that is also to be paid.
Therefore, debt investors demand a lower rate of return than equity investors. If external debt or equity is to be used, where should it be raised from and in which form? When it comes to equity finance, for some companies, the new shares must be offered to the existing shareholders in proportion to their existing holdings. With debt finance, short-term loans are cheaper than long-term borrowings. (Jay, 2003,
It is also possible that corporate financing decision is a signal to convey information to investors about the company's business risk and profitability. Jensen and Meckling (1976) show due to equity’s limited liability, shareholders and the managers that act in their interests are encouraged to approve projects that are riskier than the ones initially proposed before the debt was underwritten. Therefore, shareholders of indebted firms can obtain most of the benefits inherent in a risky project when it is successful and can avoid sharing the costs of unsuccessful projects with bondholders thanks to their limited liability. In this case, the debt’s market value would decrease and the bondholders’ loss would be the shareholders’ gain. Bondholders may want the company to reduce the size of investments to protect their own interests.
Others prefer the second stage of a company growth for the purpose of expanding the venture or during the bridging level where they provide capital for the expansion of the business until it becomes a public company. There are also companies that solely settle on supplying finances for the purpose of Management buyout. Basically Venture capitalists have the better taste of financing firms during the early stages when the level of growth is high, and late cash out when the firm is stable. The entrepreneurs either buy the investors’ stock, for a merger with another company or even liquidate the
It is because debt and equity are provided by investors or also known as owners and creditors thus, the fund provider has their expectation and demands on the firm’s profitability and growth for long term. This is one of the firm’s concern when trying to balance the ratio between debt and equity. A firm market value refers to the market capitalisation of a public traded company. It is the value of a firm according to the stock market and it is determined by the supply and demand of investors and potential investors. The market value quoted in the stock market
Transaction costs associated with external finance play an important role in selecting financing sources. Firms will first use internal equity financing, followed by external debt financing and finally external equity financing. Debt financing precedes equity issues because transaction costs for debt are lower than for equity issues (Baskin, 1989). The reliance on internal finance can also be a by-product of the desire of managers to avoid external financing because it subjects them to the discipline of the market (Myers, 1984). Especially the owner-manager of the company does not like to lose control over the firm (Holmes and Kent, 1991; Hamilton and Fox, 1998).
A number of countries are reluctant to open up their financial systems for fear of abuse. To some extent, most financial systems are underdeveloped, which makes difficult the movement of capital. In some cases, private equity is facing enormous difficulties due to administrative delays and the slow approval process of reserve banks, to exit or enter the funds. Among other difficulties, there is the high cost of borrowing (In some countries, the cost of borrowing, may up to 40%, which does not favor investment), strong tax rate and the number of experienced African t fund managers is insufficeant. There is also a lack of institutional bodies to enable the private equity industry players to discuss the issues affecting the sector.
As mention in the advantage of using long term borrowing, the company is make full responsible on the debts. When the company are not able clear the debts, the ownership of the asset will change from the company to the banks or the debtor. This will be a huge loss to the company if they take away the asset. This is because the company cannot operate as usual without the asset. The next disadvantage is repayment.