Page 26 - CIMA SCS Workbook November 2018 - Day 2 Suggested Solutions

SUGGESTED SOLUTIONS

EXERCISE 3
Briefing notes on debt finance and interest rate swaps

Prepared by: Senior Manager
For the attention of: Randal Edwards, Director of Finance
Subject: DEBT v EQUITY FINANCE

Introduction

Dorothy Novak is concerned that Novak’s debt finance has reduced during the year, even though
her MBA finance module lecturer told her that theoretically companies should increase gearing as
much as possible.

I have presented below the main practical and theoretical advantages and disadvantages of using
debt finance compared to equity finance.

Advantages of using debt finance

Low cost of servicing the debt

The required return of a lender tends to be lower than the required return of a shareholder,
because the lender faces less risk (his returns are an obligation that can’t be avoided - see
“disadvantages” below for more details). This means that the cost of servicing the debt finance
(i.e. the cost of paying the required level of return to the investor) is cheaper than the cost of
equity.

Tax relief on interest

Interest paid to lenders is paid out of pre-tax profits, whereas dividends to equity shareholders
are paid out of post-tax profits. This means that the company gets tax relief on its debt interest,
making the cost of servicing the debt even cheaper still.

Impact on overall cost of capital

As a consequence of both the two factors identified above, bringing debt finance into a
company’s capital structure tends to reduce the company’s overall cost of capital, and hence
increase shareholder wealth.

According to Modigliani and Miller’s Gearing Theory, companies should raise large amounts of
debt finance to reduce the cost of capital (i.e. as Dorothy Novak said “theoretically companies
should increase gearing as much as possible”). However, this theory is based on some
assumptions (such as perfect markets and no bankruptcy costs) which aren’t very likely to be
replicated in the real world.

Even so, an analysis of real world businesses (the Traditional View of Gearing) still shows that at
low or moderate levels of gearing a company can reduce its cost of capital by raising debt finance.

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