Why Debt is cheaper source of finance?


1

Debt is always cheaper source of finance because of following reasons.

a)      Tax benefit: The firm gets an income tax benefit on the interest component that is paid to the lender. Dividends to equity holders are not tax deductable.

 

b)      Limited obligation to lenders: In the event of a firm going bankrupt, which is what happened with Lehman Brothers, equity holders lose everything. But, debt holders have the first claim on company assets (collateral), increasing their security. So since debt has limited risk, it is usually cheaper. Equity holders are taking on more risk, hence they need to be compensated for it with higher returns.

 

c)      Limited upside: Since the equity holder has a stake in the business; he can actually participate in the potential upside in earnings. PE, Venture Capital funds usually buy stakes in high potential companies at cheap valuations, and since they have a minority stake in the company, they are entitled to a share of the profits. Plus they can exit after a few years at a fantastic premium. On the other hand debt holders have an upside limited to the fixed rate of interest they receive every year.


Like it? Share with your friends!

1
BMS Team

We, at BMS.co.in, believe in sharing knowledge and giving quality information to our BMS students. We are here to provide and update you with every details required by you BMSites! If you want to join us, please mail to [email protected].

71 Comments


Warning: Undefined array key "html5" in /home/bmsnewco/public_html/wp-content/plugins/facebook-comments-plugin/class-frontend.php on line 140

Facebook comments:

This Website Is For Sale. Email us an offer we cannot refuse on [email protected] :)

X
Choose A Format
Personality quiz
Series of questions that intends to reveal something about the personality
Trivia quiz
Series of questions with right and wrong answers that intends to check knowledge
Poll
Voting to make decisions or determine opinions
Story
Formatted Text with Embeds and Visuals
List
The Classic Internet Listicles
Countdown
The Classic Internet Countdowns
Open List
Submit your own item and vote up for the best submission
Ranked List
Upvote or downvote to decide the best list item
Meme
Upload your own images to make custom memes
Video
Youtube and Vimeo Embeds
Audio
Soundcloud or Mixcloud Embeds
Image
Photo or GIF
Gif
GIF format