Explain the factors that influence a firm's decision to choose between debt and equity financing. Then evaluate the advantages and disadvantages of (i) a bank loan and (ii) issuing debentures.
Answer
The choice depends on cost, control, risk, and flexibility; bank loans offer lower cost but higher collateral, while debentures provide no ownership dilution but higher interest burden.
Step-by-step solution
- Identify the four main factors affecting financing choice: cost of capital, ownership control, financial risk, and flexibility of repayment.
- Explain how cost of capital influences the decision – cheaper sources are preferred if they do not increase risk excessively.
- Discuss ownership control – equity dilutes control, whereas debt retains ownership.
- Describe financial risk – excessive debt raises insolvency risk; equity bears less fixed obligation.
- Mention flexibility – debt may have fixed repayment schedules; equity can be more flexible with dividend policy.
- Now evaluate bank loan: list advantage (lower interest rate compared to many other debts, tax‑deductible interest) and disadvantage (requires collateral and strict repayment terms).
- Evaluate debentures: advantage (no ownership dilution, can be unsecured, fixed interest) and disadvantage (higher interest than bank loan, creates long‑term liability).
- Conclude by relating the evaluation back to the four factors, showing how each instrument aligns with or conflicts with them.
Common mistake: Listing advantages without linking them to the influencing factors.
Concept tested: Debt vs. equity financing
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