Question

Discuss leverage, or the concept of OPM (other people’s money) as the basic funding options for most businesses. Debt involves the use of borrowed funds while equity involves selling interest in the firm. Why is this concept so important for firms to grow? How difficult is it to grow a business internally?

Answer 1

Leverage is the term used when an organization uses more debt than own equity and derive the benefit of debt. Leverage is highly used by companies nowadays in terms of growing the business or expanding the business. When there is a room for investments and there are two options mainly debt or equity to make the investment, then the debt is chosen over equity or own money. This creates leverage and shows that the company is working on other people's money. This concept of leverage is very important for a company to grow because it gives benefits of saving taxes on interests and also keeps the dilution or stakes of the firm limited to its owners. When a company works on debt, it works under pressure and works better. Performance of the company is not only dedicated to the company's owners, but it is dedicated to paying off the loan. In the process of that, they also get benefit on taxes and the dilution of capital is also not there. Also, the cost of debt is always less than the cost of equity.

While with external debt and leverage, it is easy to grow a firm, in contrast to that if we see a firm grow internally, that shows another level of difficulty as if the choice of funding is through equity, then there is dilution of capital and the firm has to bear the cost of equity which is costly. Also, with more stakeholders in the line with the firm, there will be more pressure and there will be no benefit for the firm on its profits. Growing internally is difficult as it is riskier and the outcome of growing internally and joining more people and diluting the capital can become costly on the company as compared to taking leverage with the help of debt.