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

CIMA AUGUST 2018 – STRATEGIC CASE STUDY

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. 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.

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

For listed companies, it can be expensive to raise debt finance if they choose to issue bonds on
the market. However, unlisted companies like FNG tend to raise debt finance by borrowing
money from the bank. 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.

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