Debt Financing in the Company’s Capital Structure

The impact of using more debt financing in the capital structure

A capital structure gives the mix of various capital sources that are used to fund the operation of a business. Analyzing the capital structure of a company is of utmost importance because it determines the rate at which a company grows. Further, it also dictates the amount of working capital that is available for use in a company. The management of the company needs to maintain an optimal mix of various sources of funds because the mix has an impact on the profitability, cash flows, and amount attributed to shareholders. The amount of debt in the capital structure of the company affects cash flow. Changing the amount of debt changes cash flows and equity because cash flow is attained from assets after repayment of debt and making reinvestment for future growth (McLaney & Atrill, 2008). Further, as debt increases, equity becomes riskier because the amount of profit that is attributed to shareholders decreases as a result of an increase in interest expense. The amount of dividends that can be paid at the end of a given period is also likely to decline. The cost of equity will also increase. Thus, there is likely to be a decline in the amount of shareholders’ equity. Also, the use of a large amount of debt increases the weighted average cost of capital (Eugene & Michael, 2009).

The trade-offs between incremental IPO proceeds and debt financing

It is a common practice when companies borrow money to pay dividends to pre-issue shareholders and use proceeds from the Initial Public Offer (IPO) to repay the amount of debt borrowed. The tradeoffs between incremental IPO proceeds and debt financing depending on the amount of the IPO and the debt. The trade-off can only be possible when the proceeds of an IPO are less than the initial cost of debt (Thompson Reuters, 2013).

The impact of using debt financing rather than using cash on the balance sheet

The use of debt financing has several advantages and disadvantages overuse cash. For instance, the use of debt financing eliminates the loss of interest income that arises from holding cash. This implies that the company will still maintain the stream of income it had before an IPO. Thus, there will be no significant impact on the value of retained earnings in the balance sheet. Further, by using debt, the liquidity of the company will not be altered by a large margin. This is because the company will still maintain approximately the same amount of current assets as before the IPO. On the other hand, the use of debt financing will increase the number of current liabilities. This will be caused by the proportion of long-term debt that falls due within a year. Also, debt financing will change the capital structure of the company (Firer, 2008).

How the company’s return on equity will be impacted by utilizing more debt

Return on equity is obtained by dividing the amount of net income that is attributed to shareholders by the total shareholder’s equity for the corresponding period. Interest expense that arises from using debt is deducted before arriving at the amount of net income that is attributed to shareholders. Thus, increasing the amount of debt increases the amount of interest expense. This has the effect of reducing the amount of net income that is attributable to shareholders hence reducing the return on equity. Thus, the use of more debt reduces the return on equity (Westfield, 2006).

References

Eugene, B., & Michael, J. (2009). Financial management theory and practice. USA: South-Western Cengage Learning.

Firer, C. (2008). Fundamentals of corporate finance. USA: McGraw Hill Company.

McLaney, E., & Atrill, P. (2008). Financial accounting for decision-makers. London: Prentice-Hall.

Thompson Reuters. (2013). IPO view – paying debt with IPO proceeds? Web.

Westfield, R. (2006). Fundamentals of corporate finance. USA: McGraw Hill Company.

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