Business Financing and the Capital Structure essay

Business Financing and the Capital Structure essay

Business Financing and the Capital Structure.

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Deciding the correct balance between equity and debt financing, means weighing the benefits and estimating costs of each, verifying that managers do not stick the company with debt it cannot bear to reimburse and to minimize the actual cost of capital. Choosing debt forces the management to manage cash flow, while, in a perfect economy, taking on equity means management places a priority on growth. However, in today’s credit markets, raising equity simply mean the company cannot borrow any more.  Making decision on the financing technique to use rely on long-term goals of the firm and the level of control managers want to have (Melicher & Norton, 2011). The ratio (debt-equity-ratio) used should be reasonable because the ratio is used in determining the value of the business.  The ratio is also used in measuring the management’s performance.  Although the ratio differs significantly from one industry  to  another,  the rule  of thumb holds that the ratio should range between 1:1 and 2:2.Investors like to associate  their  investments with a company that has low debt-equity ratio because more  of the firms fortunes  base on investments.  When the  ratio  is  too  high,  it means  that  the  company  has borrowed more  money than it  has invested  (highly  leveraged). The relationship ultimately creates certain ambiguity in the aims between investors and lenders.  Lenders are interested in lending small amount secured by the businesses large investment. On the other hand, investors like using a small investment and leveraging it into huge activities by borrowing.  These motivations lead into a negotiated equilibrium based on performance and market forces ( Melicher & Norton, 2011).

Debt financing involves borrowing money from an external source with a guarantee to repay the principal plus an agreed amount of interest. There are various sources of debt depending on the amount of money required and the nature of the business. They include both private and public sources. The most common sources include treasury bills, corporate and government bonds, convertible bonds, commercial papers, term loan, derivatives, certificate of deposit. The main advantage of leveraging is that, there is maintenance of ownership.  Lenders have no say on the business management.  Secondly, the interest on the loan is tax deductible hence increasing the income.

Lastly, according to MM proposition, a leveraged company has a higher value. On the other hand, debt financing has various limitations.  If the business force into bank………………………………………..