Category: Finance

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Factors are Important for Efficient Decision Making

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Why are the economic analysis and in-depth understanding of economic factors is important for effective decision making in capital market?

Investors always try to formulate best possible portfolio by investing in the capital market for the purpose of getting capital gain and dividend (cash or stock). It is not an easy task to choose best investment alternatives because the proper analysis is required. Only a specialized person would be able to analyze the market and identify the potentials. Many people think that only financial analysis is enough to make an investment but in a real sense, not only financial analysis but also economic analysis is required.

Factors are Important for Efficient Decision Making

In case of financial analysis, we only consider the company and industrial outcome through fundamental and technical analysis. But whenever we go for analysis by considering economics we have to analyze the macroeconomic factors that may have an impact on the capital market. An economist or any other professionals those have knowledge of economics can do this analysis on behalf of investors. But investors also have to have basic ideas of how economic factors can influence the price of the investment securities.

Factors are Important for Efficient Decision MakingFor efficient decision making in the capital market following economic factors should be considered

  • Inflation
  • Market Interest Rate
  • Economic Recession
  • Employment Rate

Effect of Inflation in the Capital Market

In an inflationary economy, investors have less money to invest because investors have to spend more money on their consumption. As because there is a less demand for the stock in the capital market, the price should be lower; we know that lower the demand lower the price. In the other sense in case of a company, for inflation, the production cost of the company is higher than the previous. So company’s income will be lower that stimulate the price of the stock. We know that the stock which provides more dividends to the stockholders, that stock should price higher than the other company which provides lower dividends.

Effect of Market Interest Rate in the Capital Market

If the market interest rate increases then an investor will prefer fixed income securities rather lower earning risky securities. Suppose government bond providing 10% of interest then this bond will get more preference compared with risky investment. On the other hand, if the interest rate is lower in the market then an investor will borrow the money at lower interest and invest in the capital market.

Economic Recession

Because of economic recession, there may have a positive impact on the capital market. Normally at the beginning of recession investor loose but there is always an expectation that in near future there will be positive movement in the stock price in the market, so investor prefers to invest when there is a recession. This will happened only if there is the strong form of efficiency exists in the market.

On the other hand, if there is an economic boom situation exists then there may have a possibility of declining market price movement.

Employment Rate

With the increase of a number of employees in a country per capita, income will also increase. For this people will have extra money after consumption. If people capital market is performing well then an investor will be interested to invest their surplus amount of money. So higher the employment higher the earning and it does increase the investment in the capital market.

Political Condition of a Country

Political condition is one of the main factors which have a huge impact on the overall economy and the capital market. People believe that a positive economic condition is required to maintain a stable capital market. Several financial decisions taken by the government over time to time, so it is also important to know how much preference a capital market gets from the government.

In a capital market investors basically, invest in long-term security so the investor must consider all probable aspects and economic factors before making an investment. A choice of investment in capital market can lead to a huge capital loss, so proper analysis has to done by the professional and select best opportunities.

Finally, one thing is that an investor should consider economic factors which have an impact on the capital market and proper financial and economic analysis must be done before investing in the capital market.

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Minimize the Risk from Your Investments

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How can you Minimize the Risk from Your Investments

Most of the people in this world are risk averser this means that normal people are not interested to take high risk for their investment. Although higher risk-taking behavior also can be identified by the highly ambitious people. Actually, they believed in higher the risk higher the rates of return, this type of people want to have abnormal rates of return which is much more than the average rate of return.

Minimize the risk from your investments is a very tough job if you are doing a business of single product for a particular group of people. But investment in multi-product business for a different group of people actually has the potentiality to have lower or minimum amount of risk. The reason behind this is a diversification of investment which actually helps to lower the investment risk.

minimize the risk from your investments

Now come to the point of risk minimization of your investments and how it works

There is a widely accepted concept of risk minimization introduced by the Markowitz which is known as Markowitz portfolio theory. This theory says that through forming portfolio (combinations of a different set of investment securities) by using negatively correlated securities from the available investment alternatives investor can minimize nonsystematic (risk which is not generated from macroeconomic variables)proportion of risk. Here unsystematic risk can be close to zero if an investor is able to form an optimum portfolio. Remember that although the nonsystematic/ unsystematic risk is minimized there is still has a systematic risk (arises from macroeconomic variables) which cannot be minimized.

Let’s consider an example of risk minimization

Example 1: Suppose you are doing a retail business of potato supply. You predicted that this year there will be a higher demand for potato, so you stored potato a larger quantity.

But you did not think what will happen if there is less demand for potato because of higher production and huge import from other suppliers.

So there may have a huge risk of losing your business and incurring a financial loss and you do not have any other alternative to recover this loss.

What if you conscious about the consequence that may arise and you invest your money in different products like Banana, Tomato, sugarcane, coconut supply etc. rather than investing whole money for only one business of Potato supply.

Here in this case if you lose some money from the potato business, you will still have a chance to recover it from the other business you are engaged in. So your risk is minimized by diversification.

Let’s consider another example of risk minimization

Example 2: Suppose you want to invest in the capital market to earn capital gain and yearend dividend. You have many options to choose a company from the different industry, rather doing this you select a company which is doing well in the capital market and invest all of your money. Guess what can be happened to you?

Either you can get a considerable amount of profit or you may incur a huge amount of loss. The problem is you invest all of your money to a particular company, if this company fails then you will lose. So you should your investment decision carefully to form a portfolio by investing in a different company in the different industry. So that if any company unable to satisfy then other can recover your loss and you always become gainer from the portfolio.

From these two examples, you can see that only proper diversification can help you to minimize the risk of your business/ investment. So think strategically and be a successful business person.

Points must keep in mind when you try to minimize your investment risk in the financial market

  • Choose as much as negatively correlated (one investment return is not related to other chosen investment) investment alternative.
  • Do not invest in the market without knowing what’s really going on. Is the market is over price or under price and what factors and forces changing the current market demand.
  • Do not invest in the market if you are found that the price of securities is manipulated by the syndicate.

My suggestion is always to consider investment alternatives and try to diversify as much as you can so that your risk can be minimized and you get a reasonable profit from your investment.

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Qualities of a Good Finance Manager

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Qualities of a Good Finance Manager

Finance is the lifeblood of every organization because without financing it is impossible to do any kinds of economic activities for the business organization. For profit-making organization or not for profit organization, financing is one of the core task done by the finance manager but whenever we want to evaluate the cost-benefit analysis or prospects of the profit-making organization we have to think about the proper analysis of financial statements (income statement, cash flow statement, owners equity statement, and balance sheet).

qualities of a good finance managerIn addition to this analysis finance manager is required to develop a financial model, ratio analysis, forecasting of different accounts, cash budgeting, common size statement analysis, sensitivity and scenario analysis, adapt least cost financing sources, investment decision in the profitable sectors, forming optimal portfolio to diversity investment for reducing overall risk. For all these analyses a finance manager or financial analyst has to have proper knowledge of financial terms and their changing effects on the financial condition of an organization.

Qualities of a Financial Analyst

  1. Analytical Skill
  2. Understanding of Time Value of Money
  3. Efficient User of Modern Technology
  4. Good Communication Skill
  5. Numerical Proficiency
  6. Ability to Diverse Investment
  7. Ability to Forecast
  8. Quick Decision Making
  9. Ability to Analyze Quantitative Factors

Although a finance manager needs to have different types of qualities from my point of view these are the qualities that a finance manager of a financial analyst must have.

Analytical Skills

Taking financial decision without any kind of analysis is throwing a stone in a dark hole, but an effective financial decision must not be this kind. For effective financial decision, there must be a proper analysis of historical data and all existing privately and publicly available information. So that finance manager actually can assume something about a financial outcome that may happen.

Proper Understanding of Time Value of Money

Time value of money is one of the important concepts that must be considered when making investment or financing decision for the company. Because by using this concept we can calculate the present value and future value of an amount. That’s why every finance manager has to have the clear understanding of the time value of money concept for adapting right investment or financing alternatives.

Efficient Operator of Modern Technology

Now a day’s technology made it easy to do analysis with the help of computer-based software. Popular software used for analysis are Microsoft Excel, SPSS, STATA etc. so financial analyst or financial manager must need to know how to operate this software and how to interpret the result generated by this software.

Communication Skills

Whenever a finance manager wants to analyze the financial performance of the company, he/she will be required to have financial information about the company, so through communicating with respected department manager collect information. Also what kinds of information manager are asking must be conveyed clearly to the respected parties.

Numerical Proficiency

Another important qualification of financial manager or analyst is proficiency in numerical calculation. For financial decision making most of the case we mainly use quantitative data which is a numerical number. Ability to calculate and understand numerical variables is required to take right financial decision.

Ability to Diversify Investment

One of the main tasks of financial manager or portfolio manager or financial analysis is to find out the optimal portfolio for the company from the existing investment opportunities. You know that diversification is the only way through we can minimize our unsystematic portion of the risk, that’s why managers always try to diversify their investment to maximize the return of the company. A person who has the ability to analyze the market and identify the optimal portfolio through diversification is to be the best financial manager or financial analyst for the company.

Ability to Forecast

One of the important things that a financial analyst has to do is forecasting about the future. Forecast about financing requirement and investment decision considering the future economic prospects or recession. Another thing is forecast about the growth of the overall industry and the company.

Quick Decision Making

Sometimes there may have the opportunity of making huge money through investing risky project short-term basis and these types of opportunities mainly chosen by the aggressive financial managers. Successful financial managers are quick decision makers and their decision is most of the time is an effective one. So quick decision making is the ability of person which helps to become a financial analyst.

Ability to Analyze Quantitative Factors

Although most of the cases finance manager deals with quantitative data but in some cases, they also use qualitative data also, because there may have some non-monetary factors which have a great impact on the investment and financing alternatives. So both quantitative and qualitative analytical proficiency is required to have a financial analyst to take the right decision for the company.

Educational Qualification Required to Become a Finance Manager

Not every people become the financial manager because to become a financial manager you have to understand all the necessary concept and ideas about the financing and investment. Graduated from the background of economics, finance or from accounting may become a finance manager. But now a day’s finance background people are getting more preference because of understanding of proper understanding of what finance is all about. If you dreaming to become finance manager or analyst then you should study finance first and get BBA, MBA in finance and finally try to become CFA.

Although around the world you can find there is a higher demand for finance job but in our country (Bangladesh) it was hard to find a pure financial job. But now a day’s opportunity is creating for the finance students. Hope in future there will be a higher demand of finance manager/ financial analyst in the corporate businesses.

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Role of Financial Intermediaries in Financing

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Role of financial intermediaries in financing corporate type of business in Bangladesh

Bangladesh is a developing country, where both manufacturing and service sector contributing together to our GDP (Gross Domestic Product). With the expansion of our economy individuals, organizations or institutions are engaged with productive sectors, for this purpose they need funds. The question is who will manage and supply this fund?

Basically, financial intermediaries (bank, non-bank financial institutions, investment bank) collect fund from surplus parties (those have extra idle money on hand) from an economy and then provides this fund to the deficit parties (those require fund) of the economy. For an individual, it is not easy to manage a huge amount of money within a short time, but in case of financial intermediaries, it is possible because they have the mechanism of collecting fund and then provide it to the required parties. Although the direct transfer of fund is possible it is inefficient one because there is a limitation of time, cost and availability. On the other hand, through intermediation funds can be transferred from deficit to surplus and surplus to deficit.

A corporation or corporate types of business normally invest their huge amount of capital in profitable sources so that stockholders can get a reasonable amount of return to their investment. The corporation always tries to form an optimal capital structure by combining different ratios of debt and equity. When company collects fund from the external sources it requires the help of financial intermediaries. Sometimes financing is done from a single financial institution or from two or more financial institutions. Choice of financial intermediaries depends on the cost of funds and the number of funds required.

The main thing is financial intermediary’s works as a media between the corporation’s (needs to collect fund) and surplus parties (individual or institutions), the float between these two parties is income for the financial intermediary.

role of financial intermediaries in financing

In Bangladesh, you can find there are few giant corporate houses which funding their additional debt capital with the help of financial intermediaries. Corporations like Square group, Bashundhara group, Jamuna group, ACI Group of Companies, Beximco group, Akij group etc. already acquiring thousands of crore taka and financial intermediaries made it possible.

Let’s see how actually intermediation process works and how financial intermediaries plays a role for the corporate types of business in Bangladesh.

Example 1: Suppose an economy has 1000 individuals or institutions with 10000 surplus amount of dollar each. But individually they cannot lend their money because it is hard for an individual to find deficit parties (those requires funds) when they needed. Here available deficit fund is 10 Million dollars if these funds collected by the financial intermediaries then it will be easy to lend to the corporate. If there is 2 corporate need 5 million, other 2 corporate need 3 million, and another two corporate need total 2 millions of dollar then these funds can be financed by the intermediaries as they have 10 millions of dollars to be landed.

Example 2: In case of financing a large amount of fund there is an involvement of higher risk and sometimes the amount of required funds is too much which is beyond the capacity of a single financial institution. In this case, a syndicated fund can be created by joining two or more companies together so that risk is minimized and financing of the larger amount would be possible for the corporate type business by the syndicate.

At the end of the discussion, we can identify that the financial intermediaries playing a great role in financing corporate type of business in Bangladesh through managing required funds at a time with a market interest rate. Because of the presence of financial intermediaries corporate get the benefit of lower search cost, higher liquidity, manage larger capital etc.

Written by

Md. Nahian Mahmud Shaikat

Student of MBA

Institute of Business Administration (IBA)

Jahangirnagar University

Email: [email protected]

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Determine Optimal Capital Structure

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How to Determine Optimal Capital Structure

Many people get confused about the optimal capital structure for a company because they observed that different company holding different capital structure. Capital can be formed by using only equity or combination of debt and equity, but cannot form only using debt capital. For a company debt and equity can be 50/50, for other company it can be 40/60, or 60/40, or 65/35 or any other proportion. Here question may arise that what proportion of debt and equity should use to form an optimal capital structure?

The optimal capital structure mainly depends on the two important things. These are:

  • The business risk related to the company’s business and
  • The financial risk of that company

determine optimal capital structure

Business Risk

Business risk arises when a company unable to generate a sufficient amount of cash flow to pay off its operating expenditures. Operating expenditure can be rent expense, salaries expense, wages, depreciation etc. The main thing is if the business unable to cover its business operation related expenditure then the company will exercise business risk. Lower the cash inflow, the higher the business risk and higher cash inflow from the operation will reduce the business risk.

So when forming an optimal capital structure it is required to keep in mind that the number of business risks which may arise. If there is a possibility of higher business risk then it will be a wise decision to use higher equity capital rather using debt capital. On the other hand, the company which generates a huge amount of cash flow from its business operation can use a larger amount of debt to maximize its return.

Business risk can be divided into two risk categories. One is systematic (non-diversifiable) and other is unsystematic (diversifiable) risk. As we cannot reduce the systematic we must diversify our investment so that we can reduce the risk of the company.

Financial Risk

Financial risk directly related to the interest amount payable to the debt provider. That is when a company is unable to generate sufficient cash flow to pay off the financial obligations properly then that company experience financial risk. A company with a sound financial position ensures less financial risk and the cost of debt financing is lower as the investment in this company is less risky.

Although business risk and financial risk are two broad things we have to keep in mind that some other factors like availability of equity capital, cost of equity, cost of debt, cash conversion cycle of the business, the profitability of the firm and corporate tax rate may involve with determining the optimal capital structure. Also, optimal capital structure (debt and equity ratio) depends on the type of business and economic condition of the company.

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Financial System of Bangladesh

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The Financial System is a systematic organization of institution through which surplus unit (those have a surplus amount of funds) transfer their fund to deficit units (those need funds to be financed) so that both the parties surplus and deficit unit get the financial benefit. Financial institutions or other individual financial companies use different kinds of financial instruments to transfer funds according to their needs. Sometimes people or institution collect funds directly from direct sources and sometimes they collect with the help of financial intermediaries.

The flow of funds can be possible through the following ways

  • Direct transfer of funds directly from the surplus unit (those have extra funds) to deficit unit (those need additional funds).
  • Indirect transfer facilitates the flow of funds with the help of financial intermediaries or investment bankers or investment through a mutual fund is the way of indirect transfer of funds.

financial system of Bangladesh

The financial system of Bangladesh consists of

Financial Institutions

Financial institution deals with a financial transaction where both bank and non-bank financial institutions (leasing companies, insurance companies). There are 58 banking institutions are in Bangladesh which is owned by the state, private, public, foreign companies and there are 34 non-banking financial institutions in our country. Both bank and non-bank financial institutions ensuring cost-effective transaction and flow of funds.

Financial Markets

Financial Markets are consists of money market and capital market, where money market deals with a short-term investment like Treasury bill, certificate of deposit, short-term government bond (risk-free investment). On the other hand, the capital market deals with long-term financial instruments (stock, bond, debenture etc.)

Financial Instruments

Financial Instruments are used to make transaction or investment which can be for a long term or short term. According to the demand of the market different financial institution offers different financial product so that required lending and borrowing can be possible.

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Public Financial Management Add Value

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Public Financial Management Add Value

Does public financial management add value to the actions of the corporate financial manager with respect to the public-private partnership?

To identify whether public financial management adds value to the actions of the corporate financial manager with respect to the public-private partnership (PPP) or not, we have to know about core functions of public financial management and how it works, functions of a corporate financial manager and mechanism of public-private partnership.

Basically public financial management responsible for managing funds used to provide public services (infrastructural development, power, and energy, education, water supply, sewage, national security, healthcare etc.) to different public sectors. The main objective is to ensure proper utilization of financial resources or funds so that effective public services can be ensured. Public financial management also takes care about the formulation of fiscal policy and developing a regulatory framework of financial resources of the country.

The finance ministry of a country is responsible to budget its annual sources of revenues and expenditure and also how these revenues will be collected through taxes, fees, fines, VAT etc. Two types of a budget are being prepared one is expenditure budget and other is development budget. The finance minister decides the allocation of resources according to the financial plan and requirement to the different sectors.

public financial management Add value

Here in public financial management, two important things are present which is not available for the private sector. These are:

  • Public accountability and other is
  • The balance of public goods with the requirements.

On the other hand, the corporate financial manager is mainly responsible for management of financial resources of the corporation to maximize the value of the company and shareholders wealth. Also, it is required to manage short-term money requirement through working capital management and long-term funds requirement through long-term sources or from optimal sources. To do this corporate financial manager make a decision about the capital structure of the company, capital budgeting, and working capital management.

The public-private partnership is an agreement between a public sector that is a government with the private sector that is a corporation to ensure the effective use of resources of government and corporations so that there is to have operational efficiency and cost-effectiveness. Both the parties get the benefit from this type of agreement. Now because of the failure of public sector more public-private partnerships are now seen in the recent year. The actual reason for this type of partnership is to create value for both the parties through the optimal use of the financial and physical resources.

In Bangladesh now there are 42 projects are approved and make an agreement of public-private partnership for the purpose of ensuring proper use of resources and efficient services.

Now come to the main point of adding value by the public financial management to the action of corporate finance manager in respect of PPP.

From my point of view I think it is obvious that public financial management adds value to the action of corporate finance manager through the following ways:

  • First of all corporate financial manager have to manage its financial resources by considering the financial policies taken by the government or public financial manager. In some cases corporate have to do business in an economy which is ruled by the public sector then it is required to follow the rules and regulations imposed by the government.
  • If public finance manager thinks that it is appropriate to make an agreement to form a PPP then corporate can take the opportunity because corporate have skilled human resources and expertise which is absent in the government human resource. By accepting this opportunity private sector can generate huge revenues and make it profitable sector.

Let consider an example of PPP

In Bangladesh, several projects are on hand which is under the public-private partnership. Jatrabari Flyover project is one of this until now which is a successful project. The public sector can do this project alone but it was under PPP because of the benefits of efficiency in operations, less time consuming, more quality service and make the project successful one.

Private showed their interest because of their larger financial benefit and earn reputation in the construction sector.

In this example, public sector provides its resources to the private sector and the corporate financial manager manages these resources in accordance with the agreement of public-private partnership. So we can say that the public financial management adds value to the actions of the corporate financial manager.

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Determining Financing Needs for Business

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Determining Financing Needs for Business

The success of a business depends on the effective use of financial and non-financial resources. It is the financial manager’s responsibility for determining financial needs for business and to ensure right borrowing and financing decision. Holding an optimum level of funds is not an easy task. Every manager has to go through a systematic process to decide how much money should be kept on hand as a cash and identify whether there is sufficient money to continue business operations. Also, the financial manager has to identify whether to make financing and investing decision.

Before taking any financing decision for business first of all it is required to analyze some factors and on the basis of this, it is possible to identify whether there is a deficit or surplus of funds. If there is a deficit of funds then it is required to take a financing decision.

Three things need to be analyzed when determining financing needs for business these are

determining financing needs for businessRequirements of Funds

First of all, it is required to check how much fund is required for the business over a period of time. This can be estimated through forecasting or trend analysis. Remember the requirements of funds depend upon the type of business, collection policy of accounts receivables and business operations.

Identify Profitability of the Business

After analyzing the requirement of funds the financial condition of business for a particular date should be measured where the asset and liability position can be seen. In addition to this, the profitability of the business also required to be checked. If the profitability is high then there will be more funds to spend and owner of the business will eager to spend more as he is getting more profit.

Risk Involved with Business

Here we consider the business risk which arises when a business is unable to generate sufficient revenue by using its resources to compensate its operating expenditures. If a business risk is high then it is needed to acquire funds through financing.

A financial manager must consider all these three together to determine whether he/she will finance funds for the business or not. According to the nature of the requirement, the financing can be short term or long term. It is obvious to finance short-term requirement from short-term sources and long-term from a long-term source of fund.

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Tasks of Corporate Finance

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Corporate finance is a branch of finance where financing decision about choosing a least-cost source of fund and optimal capital structure. The main tasks of corporate finance are to ensure the maximization of the value of the firm so that equity holders get the benefit. Remember one thing that corporate finance is not like public finance, both are different from each other.

The Main Tasks of Corporate Finance are

  • Capital Budgeting for the Corporation
  • Forming Optimal Capital Structure and
  • Management of Working Capital

Many people consider these tasks as a function of corporate finance. In addition to these tasks of corporate finance deals with many other financial activities according to the requirement of the corporation.

The main tasks of corporate finance

Capital Budgeting

Capital budgeting involves the long-term investment decision making by analyzing the investment alternatives. For long-term investment, a large amount of money is involved and the project manager has to spend lots of time and effort to execute the project. So before taking any long-term investment decision, it is required to make a capital budgeting. Popular forms of capital budgeting techniques are Net Present value (NPV), Internal Rate of Return (IRR), Pay Back Period (PBP), Profitability Index (PI) and Modified Internal Rate of Return (MIRR).

It is corporate managers responsibility to ensure the right amount of investment in a project by evaluating investment alternatives by using capital budgeting.

Developing Optimal Capital Structure

Another important task is followed in corporate finance is to develop an optimal capital structure for the corporation, that is choosing the right proportion of debt and equity capital. How much capital is to be raised by the debt and how much by equity fund is depends on the company’s financial strength and capability of using its resources. A company may choose fifty percent debt and fifty percent equity capital; 50:50, remember that it is not necessarily that every company use 50:50 debt and equity, a company can choose 30:70 or 40:60, or 60:40, or 45:65 ratio of capital.

Management of Working Capital

Management of working capital is the process of managing the current asset and current liabilities for the company. A corporate finance manager will decide how will he/she ensure the right amount of current asset to pay off the current liabilities. Different option available to pay off current liabilities, it can be paid off from the current asset or from the long-term asset. Whether it is to be from the long term or short term is not a matter but the thing is the cost of pay off the current liabilities. Normal practice by the corporate financial manager is to pay off current liabilities by using a current asset. To ensure a good financial position it is required to have a good working capital management system.

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Debt is the Cheapest Source of Financing

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Debt financing

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 a loan from the 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, mid-term and long-term.

debt is the cheapest source of financing

Capital Structure

Why debt is the cheapest source of financing?

A company can manage its required funds through debt or equity or combination of both. Choosing an optimal capital structure different company uses a different ratio of debt and equity. But the 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 from different sources.

Many people say that retained earnings are the cheapest source of financing but debt can be the 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 shareholders.

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 for 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 a 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 loan 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 a profit of $350000 but because of using Debt Company is making a profit of 395000. That’s why company prefers debt financing.

Let us consider another example: XYZ company take a loan at the rate of 14% and the corporate tax rate is 30%.

Here the cost of debt capital is 14% but because of using debt capital company’s cost of capital for debt 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 the cheapest source of financing for the company.

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Written by

Md. Nahian Mahmud Shaikat

Financial Analyst

Institute of Business Administration (IBA)

Jahangirnagar University

Email: [email protected]

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