30 Jun Issue of debentures – implications for decisionmakers
The use of debentures in the pattern of corporate financing has got wider and deeper significance. Recourse to debt generally tends to reduce cost of capital and consequently helps improve the overall return of the company. Debt is considered a cheaper source of financing not only because debt is less expensive in terms of interest cost and issuance cost than any other form of security but essentially due to availability of tax benefits under current tax laws.
The interest payment on debt is deductible as an expense for tax purposes. The management is, therefore, tempted to employ more and more doses of debt to meet additional financial needs of the firm. More often than not, the management finding itself almost unable to increase the overall return of the firm takes resource to debt financing for the purpose of improving the earning per share without improving the operating efficiency of the firm.
Apart from these financial considerations, non financial factors also explain the increasing use of debt than equity capital. There are times during the life cycle of many firms when additional equity funds are not available at reasonable cost but the same firms may be in a position to attract debt. Debt is also attractive since it does not disturb the controlling position of the existing owners. Besides, debt provides flexibility in the financial structure of the corporation by allowing the management to take advantage of changing cost of capital.
However, it should not be misconstrued that debt should always be used for meeting long term capital requirements. Debt brings in its wake an element of risk. This is primarily because interest and principal payments are fixed charges. If a firm has fluctuating earnings, it runs greater risk of being unable to pay its interest during lean years and of bringing a receivership with all its difficulties and losses. Further, debt proves fatal when the expectation and plans on which the debt was issued may change.
While a number of alternative methods of long term financing are under consideration, the finance manager should favor the use of long term debt if he is satisfied that sales and earnings of the company are relatively stable and will remain so in the ensuing years and the existing debt ratio is relatively low. The use of the debt may also be preferred when a substantial rise in the price level is expected in future making it advantageous for the company to incur debt.
In times of depressed stock market conditions when raising of funds through equity stock becomes difficult, the management should favor the issue of debentures. Finally, where the existing stockholders particularly a predominant few maintaining strong control over the destiny of the enterprise do not wish to part with the present controlling power, issue of debentures will be the only way out left with the management for raising external capital.