Debt financing is the act of raising operating capital or other capital by borrowing for 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 debt financing. It is one of the most commonly used ways of financing. Debt can be of short-term, mid-term, and long-term.
Why debt is the cheapest source of financing?
A company can manage its required funds through debt or equity or a 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 the 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 lender’s 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 a 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 the company making a profit of $350000 but because of using Debt Company is making a profit of 395000. That’s why the 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%. The cost of capital is reduced because of the tax deductibility feature of debt financing.
So we can say that debt can be the cheapest source of financing for the company.
Md. Nahian Mahmud Shaikat