Purchase Solution

debt financing

Not what you're looking for?

Ask Custom Question

Can you help me get started on this?

Write a five page paper discussing and explaining the following issues below. Remember that question 4 is the main part of the assignment; it should be roughly three pages out of your five page paper. Questions 1-3 should take up a total of around two pages.

1. What are the advantages and disadvantages of debt financing?

2. How does the use of debt financing affect the rate of return that shareholders require on their investment in the firm's shares? How does the cost of equity (i.e., the rate of return investors require on their investment in the firm's shares) change when the firm increases its use of debt. (This is 'Proposition II" of Modigliani and Miller for the Tax Case - see the first two articles in the required readings).

3. What is meant by "an optimal capital structure of the firm"? Be specific.

4. Now go to the main part of the Case:

Consider three companies: Adobe, T-Mobile, and Fed-Ex. Reflect on the nature of the business of these three companies. You are recommended to also get to the web site of one company in each of these categories. You might also check what the beta of each of these companies is.

Based on the readings of the Module, and upon reviewing the nature of the operations of the companies including the nature of their customers and products, what would you recommend should the capital structure (total liabilities or debt and equity proportions) be for each of the three companies? You should relate your answers to what you wrote in your response to question (3) above. Note that you are not asked to provide specific numbers, just 'low debt ratio', 'medium debt ratio' or 'high debt ratio'. (Do not quote the actual company's capital structure or their debt-to-equity ratios as per their balance sheet.)

Purchase this Solution

Solution Summary

This answer provides you an excellent discussion on debt financing

Solution Preview

Write a five page paper discussing and explaining the following issues below. Remember that question 4 is the main part of the assignment; it should be roughly three pages out of your five page paper. Questions 1-3 should take up a total of around two pages.

1. What are the advantages and disadvantages of debt financing?
The advantages of debt financing are that the bank or the institution that is lending does not get ownership rights to the firm. In addition, there is a fixed amount that has to be repaid and this is known beforehand to the borrower. The interest rate to be paid on the debt is fixed, and any excess profits earned on the investment of the money belong to the firm. The borrowing firm can run its business according to its plans if it repays the debt on time. The interest that is paid is tax deductible and this amount is reduced from the income for the purpose of taxation. In other words if the tax rate is deducted from the interest expense the cost of financing a loan becomes very low.

The disadvantages of debt financing are that the firm has to ensure that the investment generates a positive cash flow to pay for the loan repayment. Further, taking loans affects the credit rating of the firm. As the firm increases its debt financing the rate of interest charged goes up. In addition, the disadvantages with taking loans is that for some reason the rate of interest paid increases to high levels. The reasons can be varied; these include higher prime rate, history with bank, personal credit history, and the credit rating of the firm. Most importantly, if the firm fails in its business endeavors it means the company still has to repay its debt. This increases the risk of liquidation. Debt can push a company into bankruptcy and even when its assets are liquidated, the creditors get the first rights to the assets of the firm.

2. How does the use of debt financing affect the rate of return that shareholders require on their investment in the firm's shares? How does the cost of equity (i.e., the rate of return investors require on their investment in the firm's shares) change when the firm increases its use of debt. (This is 'Proposition II" of Modigliani and Miller for the Tax Case - see the first two articles in the required readings).

In very simple terms as there is an increase in debt ...

Solution provided by:
Education
  • BSc , University of Calcutta
  • MBA, Eastern Institute for Integrated Learning in Management
Recent Feedback
  • "I read your comments, and thank you for this feedback. Do I need to find other studies that applied this methodology Ive used? That's where I'm stuck at."
  • "Thank you kindly sir. "
  • "Excellent and well explained. --Thank you kindly. "
  • "Awesome notes. I appreciate you."
  • "I have the follow-up project and I will assign that to you very soon. "
Purchase this Solution


Free BrainMass Quizzes
Production and cost theory

Understanding production and cost phenomena will permit firms to make wise decisions concerning output volume.

Social Media: Pinterest

This quiz introduces basic concepts of Pinterest social media

Employee Orientation

Test your knowledge of employee orientation with this fun and informative quiz. This quiz is meant for beginner and advanced students as well as professionals already working in the HR field.

Learning Lean

This quiz will help you understand the basic concepts of Lean.

Marketing Management Philosophies Quiz

A test on how well a student understands the basic assumptions of marketers on buyers that will form a basis of their marketing strategies.