Debt financing

The difference between equity financing and debt financing is not always clear-cut. For example, preferred stock can be classified as stockholders equity or debt, depending on who is doing the financial analysis. 

Common stockholders have a right to the residual assets of a company in the event of dissolution or liquidation but only after all the creditors and then any liabihties to the preferred stockholders have been paid. The larger the proportion of debt financing in a company, the smaller the amount the common stockholders are likely to receive if the company is liqiiidated. 

Debt Financing In practice, debt financing covers a variety of fixed-income securities, both long-term and short-term. The most common forms of long-term debt are bonds, mortgages, and debentures. 

EXAMPLE B.5 EVALUATION OF USING EQUITY VERSUS DEBT FINANCING... 

Suppose you are asked to evaluate the purchase of the multicone cyclone referred to in Example 3.4. The capital investment is 35,000 (see Example 3.4), and the equipment has a class life of 5 years, after which it will be sold for the salvage value of 4000. The income stream generated by the machine is on line A in Tables EB.5A and EB.5B. As the equipment ages, its operating and maintenance costs increase, and line B lists the expense profile. Assume a tax rate of 35 percent with no investment tax credit. Evaluate two possible scenarios (a) 100 percent use of equity and (b) 100 percent debt financing. Use straight-line depreciation for debt financing, for simplicity assume equal annual payments (principal plus interest) to the lender for the 5 years at a rate of 10.5%. 

The change in the NPV using debt financing of assets is known as the principle of leverage. A similar result can often be obtained by leasing equipment because the lease payments are completely deductible as expenses for income tax purposes. 

There has been only one equity write-off, as Vantico underperformed and the debt financing covenants went into breach. Matlin Patterson acquired the debt at a discount and took control via a debt-equity swap. 

Financial markets value companies. The cycle of equity markets measured as a multiple of the current EBITDA performance of a company is important, as it influences the value and the timing of exits for financial sponsors. The availability of debt markets is equally important because LBOs require sophisticated debt financing arrangements. Conditions in both equity and debt markets have an impact on private equity investments. 

Two fundamental aspects need to be considered when assessing the impact of the financial markets on the success of private equity investments. First, all financial markets are cyclical, and the supply and demand of financial products drive the availability, volumes, and pricing of equity and debt financing. Second, European and U S capital markets provide access to different investors and therefore different market conditions. In almost all cases, the US market provides higher volumes and more favorable conditions for equity and debt transactions. 

The American Natural Resources Co. had difficulty raising money for the mammoth project which would have produced 125 million cubic feet per day of pipeline quality high-Btu gas. Officials of the company had said that normal debt financing isn t possible because lenders aren t willing to put up the money for what is still an untried process in the United States. Yet outside financing is needed because the partners in the project can only afford to put up 25% of the cost of the plant themselves."... 

All debt contracts require payment of interest on the loan and repayment of the principal (either at the end of the loan period or amortized over the period of the loan). Interest payments are a fixed cost, and if a company defaults on these payments, then its ability to borrow money will be drastically reduced. Since interest is deducted from earnings, the greater the leverage of the company, the higher the risk to future earnings, and hence to future cash flows and the financial solvency of the company. In the worst case, the company could be declared bankrupt and the assets of the company sold off to repay the debt. Finance managers therefore carefully adjust the amount of debt owed by the company so that the cost of servicing the debt (the interest payments) does not place an excessive burden on the company. 

Joseph L. Bower, When Markets Quake The Managerial Challenge of Restructuring Industry (Boston Harvard Business School Press, 1986), p. 105. In Ralph Landau s interview with Frank D. Popoff, Sept. 28, 1995, Popoff recalled that our financing has been a shameless address to debt financing for as long back as we can remember, p. 1. For Popoff s comments on the commitment to vertical integration, see ibid., pp. 4-5 (copy in author s personal files). 

The other most common sources of funding for biomedical research facilities are State and local government and debt financing by the research institution itself (207). 

Equity is only one kind of capital that companies raise. Debt financing is also used, and the cost of debt capital is generally lower than the cost of equity capital, because bondholders must be paid before stockholders are paid dividends.6 The weighted average cost of capital, r, is the blended cost of the firm s debt and equity capital (285,409) ... 

Debt financed acquisitions may come at the expense of the creditors because higher gearing corresponds with an increased risk assessment of... 

After a bond is issued bondholders can do little to counter management s activities contrary to their interests. One possibility to commit management to bondholders interests is to include covenants in the bonds indentures. A covenant may restrain certain actions (e.g., forbid to sell part of the assets ). Covenants intend to protect investors from objectionable actions, e.g., a debt financed takeover of another company. 

Again motivated by their diverging interests, shareholders favor riskier investments. This includes for example debt financed acquisitions of other companies that squeeze up gearing. The increased risk is mirrored in higher financing costs of the issuer when capital markets are tapped again. Over the longer term shareholder value sinks, too. Acquisitions to keep the issuer competitive are equally of interest for bondholders. However, they should be cautiously financed. 

Several drivers lie behind this pattern. Eor telecoms, the need to issue substantial amounts of long-term debt reflected the vast technological changes that swept over the industry at the end of the last millennium. The rapid spread of wireless communications led to the wave of partly debt-financed mergers among the major telecom service providers. In order to... 

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