Debt Financing Essay Example | Topics and Well Written Essays - 2500 words

Debt Financing - Essay Example The debt finance concept and its relevance will be explained in detail to understand its importance and develop the knowledge. Along with this, the cost of agency will be focused with the conflicts that rise during the structuring of debt finance. Subsequently, the benefits of debt financing over the agency conflicts will be discussed to know its relevance in financing in recent times. There are several arguments related to the firms’ debt financing that reflects whether the capital market is imperfect or not. There are other factors within the firms such as managers try to avoid high debt ratios to safeguard their interests in the firm (Myers, 1976). Every firm needs to borrow money for the business in short or long run and there are options such as equity, debt and others. It is important for the firms to decide the structure of finance that provides benefit. Conceptual Relevance Debt Financing Debt financing is one of the strategies which the firms employ for borrowing from the investors or lenders with a contract that the repayment will be made within a stipulated time period with certain interest (Reference for Business, 2011). The firms borrow money for raising funds for working capital or for the motive of capital expenditure through the financial instrument such as selling bonds, notes bills and others to institutional and individual investors and lenders. The institutional and individual investors and lenders become the creditors of the firms and promise that the amount and interest on the debt will be paid by the firms within the specified future date (Investopedia, 2011). The payment of debts and dividend are different. The interest and the principal amount/payments upon the debts are firm’s obligations, whereas the dividend payments are not obligations for the firms. The shareholders of the firms are not entitled legally for the dividends but the bondholders, bill holders and other financial debt instrument holders are entitled legally for the principal and interest amount from the firms (Lecture 3). According to the trade-off model the firms should issue debts as long as the marginal benefit is greater than the marginal cost. In the general financing structuring of the firms the high-tax rate firms should apply more debt than low-tax rate firms (Graham, 2008). Relationship among bankruptcy costs, agency costs and taxes is illustrated below: Source: (Pearson Education, 2004). Through the debt financing, the principal and interest that are paid are treated as expenses and thus get deducted from the business income taxes in certain cases. This allows reducing the cost through the debt financing option. Cost of Agency The agency cost is an increase of cost of debt. This happens when there are conflicts between the management and shareholders. Due to the increase in the agency-cost problems, the bondholders and other financial debt instrument holders impose certain restrictions on the firms through bond indentures. T he investors and lenders of the debt financing are aware of the fact that management is controlling their money and there are high probabilities of ‘principal-agent’ problems in the firms. Due to these two reasons the debt holders put certain restrictions or financial constrains upon the use of their money (Investopedia, 20