Principles of finance - Essay Example

? Principles of Finance Principles of Finance “In a world with corporate taxes, Modigliani and Miller’s view is that a company should issue as much debt as possible. Why is this advice not followed by companies?”A debt is often an obligation owed by a debtor to a creditor, who is usually the second party. In this case, the debtor is the companies in question. In most cases, this is termed as assets granted, particularly by the creditor to the debtor. The debtor agrees to repay the debt with an interest. Some companies use debt as part of their strategy in corporate finance. Before the debt is issued, both parties have to agree on the standard of deferred payment. In most cases, this repayment is in the mode of currency (Blum 2006). However, this repayment can be in the form of goods and services. Payment can be paid in installments or in the whole amount at the end of a loan agreement. A company offers different kinds of debts to customers to finance its operations. There are secured and unsecured debts, depending on whether the creditors have recourse to the assets of the borrower or not. In addition, there are private or public loans depending on the parties involved. One of the main reason why companies tend not to issue as much debt as possible is the fear of becoming bankrupt. If a company issues more debt than its stipulated capital, then the possibility of bankruptcy is usually high. This is especially in unsecured debts, and the borrower happens to forfeit payment. If this happens with a considerable number of borrowers, then the company can be at an extreme risk (DePamphilis 2011). Therefore, these companies offer debts amounting to the given budget. The financial advisors of the company advise the top managers on the considerable amount of debts to issue that would not alter the normal functioning of the company in any way. Secondly, a company may not be in a position to offer as much debt as possible. This is because the company may be undergoing some harsh economic times. Therefore, the company’s initial capital might be limited to offering a given amount of debt. During this period, some companies may not offer any debt at all. Therefore, the amount of debts a company offers is often guided by the economic situations of the company particularly the capital in place (Forsythyl 2009). In addition, most of the risks involved may deter a company from issuing as many debts as possible. The companies, with the help of their financial advisers, look into all the risks in all the risks involved before issuing the debts. These risks may be as a result of economic downtowns, variability in the interest rates experienced and changes in the conditions of the market. Some companies tend to take the risks but obviously at a minimum (Prattie 2011). Fewer companies are willing to take many risks, therefore, tending to issue a limited amount of debts as possible. Moreover, some of these companies tend to put in place a lot of terms and conditions required before one gains access to these loans. Therefore, some debtors tend to bark out of the lending process due to all these requirements. Some of the requirement of a company before issuance of debts is collateral mostly in the form of assets. The debtor may not possess the required collateral and, therefore, may not be legible to qualify for a debt from a certain company in question. In addition, the interest rates required by the company may be too high for the debtor not forgetting the question of having to follow the covenant made in the process. More to this is that this debt has to be repaid. Therefore, the investor or debtor in question has to have a stable cash flow to be in a position to repay in the stipulated time (Black 2010). Therefore, the appetite in making investment decisions is reduced. As a result, fewer debtors would be in a position to take the risk because a few of them have a stable cash flow. They may, therefore, fear the consequences that follow a forfeited debt payment therefore reducing the amount of debts a company issues. Taking on more debts by the company increases the agency costs between the company and the debtors (Blum 2006). Therefore, in case the company takes more and more debts and, as a result, become insolvent, the equity holders will demand to take on more risks. This is because these holders never get paid in case the company becomes bankrupt. Thus, they benefit from all these ups and downs of the company. They often do not care about the condition of the company. All the agents care about is their own benefits. Companies have taken this into consideration and thus avoid taking on more debts to reduce on this risk. As the companies in question issue more debts, the outside investors have the most appropriate say in decision making. However, these investors may not be knowledgeable about the business or may not have the same alignments as the goals of the company in question. Therefore, as this company grows a level higher, decision making becomes exceedingly slow, in addition to agency costs incurred. Therefore, the companies have to know more about the investor or debtor in question. This issue of trying to know more about the investors or the debtors may be time consuming. Therefore, these companies issue debts to the debtors they are able to gain as much information about them as possible (Brigham 2011). Most companies especially in the US use short term loans to often finance the required seasonal capital needs. Seasonal debts fluctuate throughout the year mostly going up to zero. Therefore, it is not a permanent form of financing and is not included in estimating the cost of capital. This is because the interest rate is its pre tax and is often adjusted to measure the after tax cost. In addition, these debts have no floatation costs required therefore necessitating the need for flotation adjustments (Coleman 1999). Therefore, most of these companies fail to issue as much of these short term debts as possible. Ironically, most debtors prefer short term loans because the requirements are often manageable. Initially, lenders rely particularly on the complete assessment of their marketing personnel. This is usually to estimate and determine fully the viability of a specific credit. Therefore, most companies know whether a debt is to be made after the successful completion of an audit. As a matter of fact, most of these debt sheets end up not to be made (DePamphilis 2011). This company as a result spends a lot of time and money in audit and other expenses that arises. In addition, when the debt is made, the senior management involved may find out that the covenant put forth may be different from the original thus delaying the process further. Thus, this reduces the number of debts issued. The senior managers in the company, however, may have to deal with inferior terms put in place to make successful completion of that economic year. Moreover, most of marketing and financial advisers employed by the companies may be inexperienced. They may find themselves moving from debtor to debtor. Therefore, they are unable to make an accurate assessment whether a company is viable to make a particular debit or not. Since account executives are often employed by an individual financial institution, they are unable to ascertain the prospective borrower of the company’s achievement of financial goals than the prospected intermediary third party. Therefore, with lack of this crucial information, the debtor may not be confident with the company to extent of taking a debt from them. As a result, the prospected debits to be made by the company are reduced (Ehrhardt 2011). Moreover, approval for debits especially loans vary spontaneously. This makes it exceptionally difficult for senior management to make the required choices according to the required debtors. Therefore, companies may be unable to make the required number of debts because they are not aware of the potential debtors and their intentions (Forsythyl 2009). These mangers may be therefore afraid of all the risks involved in establishing and maintaining a perfect lender and borrower system. Most of these companies are in search of certain categories of people to qualify for these debts. However, the company may be located in an area where finding such clients tends to be difficult. Therefore, these companies are unable to lend to as many individuals as possible due this reason. In addition, the debtors around the area where the company is located may not be aware of the merits involved in borrowing from a company. They may be harboring the worst perspectives of these companies and thus inhibiting them from engaging in this activity. These companies, on the other hand, may not be taking any initiative in educating people on the advantages of undertaking a debt. Mostly to the companies located in the rural areas. You find out that most of the inhibitors of these areas are illiterate or semi illiterate. Therefore, they may be totally naive about all these borrowing and lending issues (Meiners 2012). These companies should therefore undertake seminars among these residents because they never know; those residents could be their prospective borrowers in future. Discrimination of these members on the basis of their educational and economic background results into this decline. Moreover, some companies discriminate against their potential debtors on the basis of their educational back ground or their economic status. This is often visible when perspective debtors are turned off by the management because of their status. This management is often afraid of these debtors forfeiting payment (Prattie 2011). Lack of the initiative and free will to undertake these risks drives these potential debtors away. Therefore, the company is unable to make as numerous debts as possible. In conclusion, a company should be in a position to undertake as many debts as possible. For this to succeed, these companies have to be potentially prepared to face the risks involved. Moreover, these companies should have the required capital and budget in advance, to avoid final frustrations which might be caused by their insufficiency. These companies should not discriminate on anyone on the basis of economic or educational background. Instead, they should put into consideration other factors far more crucial in this link. In addition, the companies should be considerate with the interest rates they offer to their potential debtors, to attract as many debtors as possible (Winslow 2009). References Black, K 2010, Business statistics : for contemporary decision making, John Wiley, Hoboken. Blum, B 2006, Bankruptcy and debtor/creditor, Aspen Publishers, New York. Brigham, E 2011, Principles of finance, South Western College, California. Coleman, P 1999, Debtors and creditors in America : insolvency, imprisonment for debt, and bankruptcy, Beard Books, Wahington DC. DePamphilis, D 2011, Mergers, Acquisitions, and Other Restructuring Activities : an Integrated Approach to Process, Tools, Cases, and Solutions, Elsivier Science, Burlington. Ehrhardt, M 2011, Financial management : theory and practice, South Western Cengage Learning, Mason. Forsythyl, W 2009, A treatise on the law relating to composition with creditors, Beard Books, Washington DC. Meiners, R 2012, The legal environment of business, South Western Cengage Learning, Mason. Prattie, J 2011, Financial Accounting in an economic text, John Wiley, Hoboken. Winslow, R 2009, The law of private arrangements between debtors and creditors. With precedents of assignments and composition deeds, Clowes and Sons, London. 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