debt financing

Examples of debt financing in the following topics:

• Trade-Off Consideration

  • The trade-off theory of capital structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits.
  • An important purpose of the theory is to explain the fact that corporations are usually financed partly with debt and partly with equity.
  • It states that there is an advantage to financing with debt—the tax benefits of debt, and there is a cost of financing with debt—the cost of financial distress including bankruptcy.
  • Therefore, a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.
  • As more capital is raised and marginal costs increase, the firm must find a fine balance in whether it uses debt or equity after internal financing when raising new capital.

• Tax Considerations

  • Taxation implications which change when using equity or debt for financing play a major role in deciding how the firm will finance assets.
  • When the theory is extended to include taxes and risky debt, things change.
  • Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases.
  • In general, since dividend payments are not tax deductible, but interest payments are, one would think that, theoretically, higher corporate tax rates would call for an increase in usage of debt to finance capital, relative to usage of equity issuance.
  • In the end, different tax considerations and implications will affect the costs of debt and equity, and how they are used, relative to each other, in financing the capital of a company.

• Capital Structure Overview and Theory

  • For example, a firm that sells 20 billion dollars in equity and 80 billion dollars in debt is said to be 20% equity-financed and 80% debt-financed.
  • The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage.
  • It states that there is an advantage to financing with debt (the tax benefits of debt) and that there is a cost of financing with debt (the bankruptcy costs and the financial distress costs of debt).
  • This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, while debt is preferred over equity if external financing is required.
  • Thus, the form of debt a firm chooses can act as a signal of its need for external finance.

• Types of Private Financing Deals: Going Private and Leveraged Buyouts

  • LBOs use debt to secure an acquisition and the acquired assets service the debt.
  • A leveraged buyout (LBO) is an acquisition (usually of a company, but it can also be single assets like a real estate) where the purchase price is financed through a combination of equity and debt, and in which the cash flows or assets of the target are used to secure and repay the debt .
  • As financial sponsors increase their returns by employing a very high leverage (i.e., a high ratio of debt to equity), they have an incentive to employ as much debt as possible to finance an acquisition.
  • Senior debt: This debt is secured with the assets of the target company and has the lowest interest margin
  • Junior debt: This debt usually has no securities and bears a higher interest margin

• Total Debt to Total Assets

  • The debt ratio is expressed as Total debt / Total assets.
  • Debt ratios measure the firm's ability to repay long-term debt.
  • The debt/asset ratio shows the proportion of a company's assets which are financed through debt.
  • If the ratio is less than 0.5, most of the company's assets are financed through equity.
  • If the ratio is greater than 0.5, most of the company's assets are financed through debt.

• Debt to Equity

  • The debt-to-equity ratio (D/E) indicates the relative proportion of shareholder's equity and debt used to finance a company's assets.
  • The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets.
  • The formula of debt/equity ratio: D/E = Debt (liabilities) / equity.
  • A similar ratio is the ratio of debt-to-capital (D/C), where capital is the sum of debt and equity:D/C = total liabilities / total capital = debt / (debt + equity)
  • The debt-to-total assets (D/A) is defined asD/A = total liabilities / total assets = debt / (debt + equity + non-financial liabilities)

• Debt-to-Equity Ratio

  • The Debt-to-Equity Ratio is a financial ratio that compares the debt of a company to its equity and is closely related to leveraging.
  • The Debt-to-Equity Ratio is a financial ratio indicating the relative proportion of shareholder's equity and debt used to finance a company's assets, and is calculated as total debt / total equity.
  • Debt is typically a long-term liability that represents a company's obligation to pay both principal and interest to purchasers of that debt.
  • Calculating a company's debt to equity ratio is straight forward, and the debt and equity components can be found on a company's respective balance sheet.
  • For more advanced analysis, financial analysts can calculate a company's debt to equity ratio using market values if both the debt and equity are publicly traded.

• Striking Agreements to Avoid Bankruptcy

  • Negotiation may also buy the debtor some time to rebuild finances.
  • A debt restructuring is usually less expensive than bankruptcy.
  • Debt restructurings typically involve a reduction of debt and an extension of payment terms.
  • A debtor and creditor could also agree to a debt-for-equity swap, wherein a company's creditors generally agree to cancel some or all of the debt in exchange for equity in the company.
  • This simplifies the debtor's obligations and can result in faster debt repayment.

• The Public Debt

  • Government debt, also known as public debt, or national debt, is the debt owed by a central government.
  • Government debt, also known as public debt, or national debt, is the debt owed by a central government.
  • Government debt is one method of financing government operations, but it is not the only method.
  • Government debt can be categorized as internal debt (owed to lenders within the country) and external debt (owed to foreign lenders).
  • However, central banks may buy government bonds in order to finance government spending, thereby monetizing the debt.

• Corporate Bonds

  • The opposite of secured debt is unsecured debt, which is not linked to any specific piece of property.
  • Senior debt has seniority over subordinated debt in the issuer's capital structure.
  • Subordinated debt is repaid after other debts in the case of liquidation or bankruptcy.
  • Such debt is referred to as subordinate, because the debt providers (the lenders) have subordinate status relative to the normal debt.
  • Because subordinated debt is repaid only after other debts have been paid, they are riskier for lenders.