Question

Suppose you are the owner of a small woodworking business that is privately incorporated. Your currently own 100% of the business (equity valued at $100,000), with no long term debt. You are looking to purchase a new piece of equipment costing $10,000 that will require funds that you do not have available. How would you choose to finance the equipment? Explain the reasoning behind your decision.

Answer 1

In this case, the business requires to purchase a new piece of equipment costing $10,000 and the company is currently 100% funded by the owner. I would choose to fund the purchase of new equipment with long term debt due to the following advantages of having long term debt in company:-

1. Debt is least costly source of long-term financing. It is the least costly because:

* Interest on debt is tax-deductible,

* Bondholders or creditors consider debt as a relatively less risky investment and require lower return.

2. Debt financing provides sufficient flexibility in the financial/capital structure of the company. Flexibility in capital structure of the company can be increased by inserting call provision in the bond indenture. In case of over capitalization, the company can redeem the debt to balance its capitalization.

3. Bondholders are creditors and have no interference in business operations because they are not entitled to vote.

4. The company can enjoy tax saving on interest on debt.

So, it is best for the company to raise fund through long term debt source.