Is Debt a Bad Thing and Should Companies Be Advised to Avoid It - Assignment Example

Corporate Finance Name of the Class Professor Name of the School City and state Where it is Located Date a) Outline the debate between the traditionalists and modernists as to whether an optimal capital structure can be achieved. The capital structure of one of the most essential choices and when viewed from a technical perspective it can be termed as the careful balance between the equity and debt that a business makes use of so as finance their day to day operations, assets as well as their future growth (Rosenbaum and Pearl 2009). The traditional view of capital structure implies that there is an optimal debt to equity ratio where the overall costs of capital is usually at a minimum and the market value of the firm is seem as being the maximum. In instances where there are certain changes in the financing mix there are usually positive change to the value of a firm. Prior to this point, the marginal costs of the debt is usually less when compared to the cost of equity and after the point the vice versa is also true (Brealey & Stewart 1991). A major advantage of making use of the traditional view of capital structure is that if it adhered to the firm value can be increased to a certain level. Another advantage is that it cautions businesses on the best way to operate in that there is a certain extent to which debt should exists and in instances when firms detect that they are going beyond that point they are cautioned on stopping since increase in leverage will likely result on the reduction of the firms value (Chang Lee & Lee 2009). Despite the advantages, the traditional view also has a number of criticisms. The traditional view shows that the investors’ value levered firms as opposed to the unlevered ones. This means that they are willing to pay a premium to own shares in the levered firms. The argument of the traditional view is that the moderate amount of the debt in firms that can be viewed as sound do not in any way add to the riskiness of the share and this argument is nor defensible in any way. Additionally, there is no justification for the assumption that have been made that the investors perception of risk is different at the various levels of the leverage (Lindsey 1986). A good example of a modernist view of the corporate finance is the Modigliani-Miller theorem. The modernist view disregards very essential factors in the capital structure, for example, fluctuations and other uncertain situations that can occur in the financing of the firm. Based on the modern view, in a perfect market the manner in which a firm is financed is not in any way relevant to its value (Margaritis & Psillaki 2010). This usually results into offering an effective base with which the real world reasons for the capital structure can be examined and termed as relevant. This implies that the value of company is in away affected by the capital structure that it chooses o make use of at any given time. There has been a lot debate on whether an optimal capital structure can be achieved though it can be achieved it is usually face by a number of constraints. It is crucial to note the concept of appropriate capital structure seems to be more realistic as opposed to the idea of an optimum capital structure. Traditional arguments argue for the argument that there is a time when an optimal capital structure can exist (Mishra & McConaughy 1999). At the same time it is difficult to obtain an optimal capital structure since it usually impossible for firms to predict the exact amount of decreases that may occur in the terms of the market value since the market factors that tend to influence the market value of equity share are complex. Additionally it would be crucial to note that the market price of the equity share rarely experiences any changes as a result of changes in the debt and equity mix thus no optimum capital structure can be achieved (Myers & Majluf 1984). b) Compare and contrast the sources of medium and long-term finance available to a newly formed private company (trading less than 2 years) and a well-established private company (trading for 20 years). The achievement of goals of corporate finance calls for an appropriate financing of the corporate investment. The sources of financing are generically termed as the capital that is self generate by a firm or also the capital that is obtained from a number of external funders. In most instances the management teams in firms makes use of both the short term and the long term financing. In respect to these, they need to match the long term sources of financing or short term financing with the assets that are being financed and this needs to be done in terms of their cash flows and the timing (Afrasiabi &Ahmadinia 2011). Firms mainly seek long-term financing to acquirement new equipment, cash flow enhancement, research and development and for expansion of the company. The most common and major forms of long terms includes equity financing, corporate bonds and capital notes. Equity financing entails the common stocks and the preferred stocks and they are seen as less risky in terms of the cash flow commitments. Howver it would be crucial to note that they do not in any way lead to a dilution of the share ownership, earnings and control. The corporate bonds are termed as bond is usually issued by corporations so as to raise money more effectively in a bid to expand their business. The capital notes on the other hand are termed as a convertible security that is exercisable into shares and they are termed as essential equity vehicles. The capital notes are in a way similar to the warrants but the only difference is that they lack an exercise price or an expiration date. In most instances, the capital notes are usually issued with a close connection to the debt for equity swap restructuring and this means that instead of issuing of the shares that can replace the debt in the present, the creditors are given convertible securities and based on these the dilutions occurs at a later date. The short terms forms of financing are usually used over a very short period of time for example a period that do not exceed one year and it assist the corporation in that it can increases its inventory orders, daily supplies and payrolls. Some of the most common forms of short term financing includes the commercial paper, asset based loan, promissory note letter of credit and repurchase agreements (Cespedes & Molina 2010). A commercial paper is termed as unsecured promissory note and it has a fixed maturity date and this mainly takes place within one year in the global money market. This is usually issued by large corporations so as to get financing so as to meet the short term debt obligations of firms. This kind of financing is usually backed by the issuing bank or by the corporation’s promise that the face amount will be paid on the date that has been specified. The promissory note is termed as a negotiable instrument and in it one of the party which is termed as the issuer or the maker makes an unconditional promise and mostly this is done in writing that they will pay a determinate amount of money to the other and this is done at a determinable or fixed future time or when the payee demands and this is done under certain terms (Mahajan & Tartaroglu 2008). The other form of medium term financing is asset-based loans and it is usually secured by use of assets of the company. In most instances accounts receivable, real estates, equipment and inventory are some examples of assets that are used to back up the loans. This kind of loan can be at times be backed up by a single category of assets or at times there may be a need to combination of assets if the amount required is high and cannot be guaranteed by one asset. The other form of financing is the repurchase agreements (Kochhar & Michael 1998). This kind of loan is arranged by selling the securities to an investor and there is an agreement that there will be a repurchase at a fixed date and price. The last form of financing is the letter of credit and it is a document that is issued by financial institutions to as seller of the goods and services and it ensures that issuer pays the seller for goods and services that the seller delivers to a buyer (Vasiliou & Daskalakis 2009). The promissory note is an effective short term form of financing that can be applied by a newly formed private company. The newly formed company can also make use of the repurchase agreements and the asset based loan since they will have something that acts as collateral for them and this will make the issuance of the loans easier and quicker as opposed to seeking other forms of financing. Equity financing seems to be the best suited method of long-term financing for newly established firms (Hamilton 1990). Based on the various medium and long-term financing that is available for companies a commercial paper is well suited form of short term financing that can be used by a well established private company. This is based on the fact that since the financing is not in any way backed up by any form of collateral only firms that have excellent credit rating from recognizable rating agencies can make use of the commercial paper (Salehi & Biglar 2009). A well established company can also make use of the letter of credit since they are more likely to because it acts as a guarantee that the seller will be paid by the issuer of the letter and this happens regardless of whether the buyer ultimately decides not to pay. In regard to the long term forms of financing a well established company can make use of corporate bonds and capital notes (Graham & Campbell 2001). c) Is debt a bad thing and should companies be advised to avoid it? 600 Short term debt is defined as the account that is shown in the current liabilities section in the balance sheet of a company. The account includes the debts incurred by a firm and it is due within a period of one year (Mishra & Tannous 2010). This kind of debt is made up of the short term banks loans that the company has taken among others. The long-term debt on the other hand entails the loans as well as financial obligations that last for a period that exceeds one year. This kind of debts can include any leasing and financing obligations that are due within a time frame that is greater than twelve months. Gearing on the other hand is a technique that involves the use of funds that have been borrowed when purchasing an assets with the expectation that the after tax income from the asses and the asset price appreciations will in a way exceed the cost of borrowing (Kolasinski 2009). In such instances, the finance provider usually sets a limit on how much they are prepared to take and at the same time they will take a limit the amount of leverage that they can permit and would require that the asset that have been acquired to act as the security for the loan to be offered. Companies with high gearing can be considered to be at more risks as compared to those companies that without high level gearing. This is based on the notion that companies with higher gearing have the opportunity to operate with high levels of debts and in instances when some unexpected circumstances happen they are affected best (Brigham 1989 and Romano 2001). Companies cannot in any way survive in high levels of gearing and with time they need to keep reducing their gearing to an optimum figure and this will help them in avoid the associated risks. Debt is a bad thing and companies should always avoid them and more so when do not have an effective plan in which they plan to use to pay the loan back. But in some circumstances debt can be a good thing and more so when it in way contribute to the organizations, for example, when they need some equipments to make improvements in their products and service delivery. This is usually the case when the forecast shows that the company will make to repay the incurred debt (Baker & Wurgler 2002). References Afrasiabi, J &Ahmadinia, H 2011, ‘How financing effect on capital structure, Evidence from Tehran Stock Exchange (TSE)’, International journal of academic research, vol.3, no. 1, pp. 309-316. 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