The Major Advantage of Debt Financing - Case Study Example

Debt A debt is the borrowing of money. It may be between two individuals, organizations, banks and even government. Debentures, bonds, loans and commercial papers are all examples of debt. It has to be repaid at date decided when it is provided, usually at an interest prevailing in the market. Sometimes a rate of interest, lower than the market, can also be obtained. Types of debts with duration: There are basically two types of debts which are characterized as long term and short term. Long term: Long term debt is the kind of debt whose payment takes a period of over one year and is accompanied by payment of interests. Short Term: The short term debt is the debt which is to be paid with or without interest within a period of one year. It mat includes bank overdrafts etc. Advantages of debt financing (Peavler) Accountability: The major advantage of debt financing is that one is not at all accountable to the lender. He is in total control of the business affairs. Nobody has a right to take any decision except the owner. However, in equity financing the lender obtains the status of the owner and he is also involved in the decision making of the business affairs. (Peavler, R.) Deduction: The other major advantage is that the interest is an allowed tax deduction. This means one has to pay lower tax on his income. Whereas, in equity financing dividend paid to the shareholders is not allowed as a tax deduction. Profitability: Another major advantage is that the lender has no rights in the profits earn by the owner of the entity. The owner enjoys the profits of the company only. The owner is only required to make repayment of the loan on timely basis. Future Loans: Another advantage of debt financing is that when an owner acquires a good rating in the repayment of loan on timely basis than he can obtain future loans as well easily. Documentation: There is not much documents involved in debt financing. It can easily be obtained with less paper work. It is cheaper than equity financing when compared in short term. Disadvantages of Debt Financing (Peavler) Effects of smaller organizations: Debt financing for smaller organization may be dangerous. Even though it makes one organization easier to make payments of expenses on day to day basis but still it has one major disadvantage. Usually smaller organizations find it difficult in the repayment of loans especially those on short term basis. Moreover, if they miss payments, it become obligatory to make heavy interest payments, sometimes the whole debt become due and most importantly the organization faces a big problem in credit rating. Pledging: Pledging is another issue. Smaller organizations are required to pledge their personal assets and in case they go low on cash, they will lose their assets. Availability: Sometimes the availability of such financing is only limited to bigger organizations. Government Debt Ordinarily, every state tries to meet its usual expenditure out of the current revenue. If at any time, emergencies arise, and then the state, for accelerating economic growth raises loans from its citizens at home and foreigners abroad. State also undertakes loans for commercial purposes like construction of roads, railways etc. sometimes it is also incurred for covering a temporary deficit in balance of payment. The sum-total of all the state loans whether it is incurred for exploiting the natural resources of a country or for meeting or preparing for the war, or any commercial purposes, etc. is termed as Government Debt. (Hansen, A. H., 1941) Hicks has further divided it into three classification i.e. deadweight debt, passive debt and active debt. It is that debt which is incurred in an economy which is used for non productive purposes such as loan raised during war period is a deadweight debt because for such debts no real assets exist to balance them. Passive debts are those debts which are incurred to provide enjoyments to the citizens such as public parks, museums, public buildings, etc. While Active debts are those debts which are spent on those projects that directly help in yielding money income and increasing the productivity of the economy. (Hansen, 1941) Forms of State Borrowing State can raise loans in different forms. It may obtain loans from people within the country or from other states or by issue of inconvertible paper currency. There is always a limit of borrowing in each case whichever method is adopted by the state. If that limit is crossed, the country is bound to suffer. We discuss below the various forms of state borrowing and also the limit to which the state can borrow. Internal Borrowing When the state finds it difficult to raise its revenue by taxation then it resorts to borrowing from citizens and financial institutions within the country. That may fall into short term loans or long term loans or both. Now, it depends upon the socio-economic conditions of the country that how much loan the state will obtain. The state can also raise loans from the Central Bank of the country. The Central Bank purchases the government securities, bonds and debentures from the government and advances loans against them. External Borrowing It is that loan which is raised through international money markets, foreign governments and international agencies such as IMF. When a state is in need of money, it tries to get as much loan as it can from other states. Foreign governments take into account many factors before giving the loan such as tax bearing capacity, per capita income and many more. Most importantly, foreign governments only advance loans with limits. Effects of debt on the U.S. As the recent recession had many major effects on some of the major economies of the world, U.S. was one of those economies which were very exposed to this crisis. This crisis, as it involved the financial institutions mainly, had a lot to do with the debts and mainly government debt. Trade deficit: One of the major issues that the U.S. government had to encounter was in the form of their trade deficits. They had a view that it couldn’t affect the economy because the foreign people can easily finance it. One of the major harms it had on the U.S. economy was in form of loss in income generation. (Daily Reckoning, 2010) The recession led to a great deal of debt growth for the country which can generate future trade deficits as well. Debt growth: It had a great impact on the budget deficit that prevailed over the period due to the recent crisis in the U.S. It seemed to be beneficial in the short run as the people of the country gained a lot of advantage on the deficit spending but it grew larger soon and the government was subjected to payment of large amount of interests. (US Economy, 2010) Since the loans got really high, government needed to identify more resources in order to repay these debts. This either had to result in a raise in the tax rates or the obvious part, i.e. more borrowings. The government obtained more borrowings which also had a negative impact on not only the governments paying capacity but also on the currency i.e. Dollar. Works Cited Hansen, A. H. (1941). Fiscal Policy and Business Cycles. Peavler, R. (n.d.). About.com:Business Finance. Retrieved from Debt and Equity Financing: http://bizfinance.about.com/od/generalinformatio1/a/debtequityfin.htm Daily Reckoning. (2010). Retrieved from http://dailyreckoning.com/us-recession/ US Economy (2010). Retrieved from http://useconomy.about.com/od/fiscalpolicy/p/US_Debt.htm Read More