Page 27 - CIMA SCS Workbook November 2018 - Day 2 Suggested Solutions

CIMA NOVEMBER 2018 – STRATEGIC CASE STUDY

Flexible terms

When a company raises debt finance, it can negotiate terms with the lender to tailor the finance
to the circumstances. So for example the debt could be long term or short term, and repaid all at
one at the end or in stages during the period of the borrowing.

Cheap and simple to arrange

Admittedly, for listed companies (like Novak) it can be expensive to raise debt finance if they
choose to issue bonds on the market. However, debt can also be raised by borrowing from banks.
This is simple to arrange, and arrangement fees tend to be low.

Disadvantages of using debt finance

Interest is an unavoidable obligation

When a company borrows money, it signs a binding contract with the lender to pay interest and
capital repayments on specific dates. This is different from equity, where dividend payments are
made at the discretion of the directors.

Therefore the biggest risk to the company of using debt finance is that it can’t afford to meet
some of these payments and ends up being liquidated.

For this reason, if a company wants to invest in a project whose returns are likely to be volatile,
equity would be a preferable source of finance.

Redeemable

Companies rarely promise to repurchase shares when they issue equity finance, but debt finance
(usually) has to be repaid. This can put tremendous pressure on the company’s cash position.

Covenants / security

Lenders often insist on covenants and or security when lending. These can restrict a company’s
activity - effectively the lender becomes a more powerful stakeholder who has greater influence
over the directors’ decisions.

Conclusion
The key issue is that debt finance is cheaper than equity, but it can impose restrictive obligations
that a company might struggle to comply with.

Overall though, it is generally accepted that a company should have a combination of debt and
equity finance in its capital structure. That is it should raise some debt finance to take advantage
of the lower costs, but not have too much debt so that the interest and capital repayments
become too onerous.

88 KAPLAN PUBLISHING