Debt Financing Advantages And Disadvantages

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. The interest rate is of least consideration here because in any case, the principal amount must be paid back. If any private firm is unable to do so, automatically the property and assets in the name of the firm are exposed. Often young companies face

A systematic outflow of cash every interval can leave the rough bumps in the cash flow. Also, this mode of financing is done against the future earnings. The opportunity cost is very high. The money to repay the loans could’ve been used to invest. The result is very certain that the portion of the money that could’ve been allocated to expand the business will now go to the payment of the debt. It is all subjected to the nature of the firm. If the firm is capable to liquidate with flexibility i.e. the liquidity ratio is high then paying off debt would be not as difficult. But an overuse of debt can severely limit future cash flow and stifle growth. With reference debt financing in corporate investments, the findings were

They have found through empirical evidence that both show a positive relation. Trends have shown that an increase in debt financing leads to an increase in leasing. This act financially bad for private firms who run on lease on is a stakeholder of it. The firm has more cash outflows since it is paying for the debt and the lease.

“This paper demonstrates that, because leasing is a mechanism for selling excess tax deductions, it can motivate the lessee firm to increase the proportion of debt in its capital structure relative to an otherwise identical firm that does not use leasing. Thus, debt and leases can be complements.” (Lewis and Schallheim, 1992)

Furthermore, the inflation factor can act as a cost to the firm itself. If the inflation is unanticipated then the lender cannot react to the situation. But getting a debt financing in a time where the lenders can anticipate the inflation, they will demand for inflation premium in the nominal interest rate. So this additional payment would not be considered as an expense but as a charge against profits.

Finally, the establishment that debt financing brings tax advantage is reexamined. The formula used to calculate