Debt financing is the act of raising operating capital or other capital by borrowing for a business. Most often, this refers to the issuance of a bond, debenture, or other debt security.
When a company takes loan from third party then it is considered as debt financing. It is one of the most commonly used ways of financing. Debt can be of short term, midterm and long term.
Why debt is the cheapest source of financing?
Company can manage its required funds through debt or equity or combination of both. Choosing an optimal capital structure different company use different ratio of debt and equity. But question is how an optimal capital structure can be formed. Basically the capital structure is formed by considering the financial strength of the company and cost of funds of different sources.
Many people say that retained earnings is the cheapest source of financing but debt can be cheapest source of financing from different perspectives. From the share holder’s perspective tax deductibility feature of debt finance is lucrative. And from the lenders perspective debt is secured because creditors get the preference of getting their principal and interest before making any benefit to the share holders.
Tax deductibility feature of debt is the main point, on which we can say debt is the cheapest source of financing.
There are some other points that may include with deductibility feature. These are
- Time value of money and preference of funds.
- Dividends not payable to lenders
- Interest rate.
Let us consider an example to show how debt financing helps to reduce the tax burden that is the tax deductibility features of interest.
Example: Suppose XYZ company take loan of $1000000from ABC bank at the rate of 15%. Tax payable to the government is 30% of the income. Income is = $500000
Only Equity is used
If there is no debt financing then XYZ company has to pay tax of total = $500000 X 30% = $150000
After tax income = $ 500000 – $150000 = $350000
If Debt and equity is used
On the other hand if company use debt financing then,
Interest on load amount = $1000000 X 15% = $150000
Taxable income is = $500000 – $150000 = $350000
Tax payable = $350000 X .3 = $105000
After tax income is = $500000 – $105000 = $395000
From the example it is clear that because of debt financing XYZ Company is paying less amount of tax which increases the net income after tax. Normally company making profit of $350000 but because of using Debt Company is making profit of 395000. That’s why company prefers debt financing.
Let us consider other example: XYZ company take loan at the rate of 14% and corporate tax rate is 30%.
Here cost of debt capital is 14% but because of using debt capital company’s cost of capital for debut is 14 X (1 – 30%) = 9.80%. Cost of capital is reduced because of tax deductibility feature of debt financing.
So we can say that debt can be cheapest source of financing for the company.
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Md. Nahian Mahmud Shaikat
Institute of Business Administration (IBA)
Email: [email protected]
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