Question

0. Discuss pros and cons of debt financing in contrast to equity financing in capital budgeting. What are the implications of each for shareholders’ wealth maximization?

Answer 1

Benefits of Equity financing:
1. The dividends need not be paid regularly by the firm and can be paid as per the requirements or capability of the firm.
2. It can be permanent in nature.
3. Firms can increase or decrease share price by buying back shares or issuing bonus or extra shares.

Demerits of Equity Financing:
1. The partnership of the firm is diluted in this case
2. Cost of equity is highest as compared to other forms of financing.


Benefits of debt financing:
1. Cost of debt is very low due to the tax benefit it provides.
2. It can be borrowed to the level that it can provide optimum cost of the capital

Demerits of Debt Financing:
1. Excess leverage increases risk in the firm
2. More debt might reduce credit rating and incremental cost of debt increases.
3. More debt during recession can significantly reduce EPS.

Optimal Debt equity ratio helps in increasing return on Equity. More Equity might increase cost of capital . An optimal debt equity structure minimises the WACC for the firm. Since debt is tax deductible optimal debt is paramount, whereas equity reduces risk in the firm but is expensive.