Why do firms borrow capital that has to be repaid rather than finance a firm with 100% equity?

Authors Avatar

Why do firms borrow capital that has to be repaid rather than finance a firm with 100% equity?

Index

                                                                                                                                                                                        Page

  1. Introduction…………………………………………………………………………………1

  1. Literature Review

  1. Types of finances……………………………………………………………….1

  1. Bank borrowing/ bank loan……………………………………………….1-2

  1. Bank overdraft……………………………………………………………………2

  1. Mezzanine debt…………………………………………………………..……..2

  1. Equity financing…………………………………………………………….…..3-4

  1. MM view against traditional method……………………………………….….4-6

  1. Bankruptcy……………………………………………………………………………….….6

  1. Agency theory……………………………………………………………………………..7-8

  1. Conclusion…………………………………………………………………………………….9-10

  1. Bibliography

1.0 INTRODUCTION

 

Investing requires finance, thus, businesses need to raise capital and there are many different types of finances available to them. Therefore, this study will look into the types of finances available to the company along with the advantages and disadvantages of each type of finance and the advantages and disadvantages of equity financing followed by the MM view against the traditional view, bankruptcy risk and the agency theory. And finally, a conclusion will be drawn based on the study stating why firms borrow capital that has to be repaid rather than finance a firm with 100% equity 

 

2.0 LITERATURE REVIEW

2.1 Types of finances

Although there are many forms of finances available for a company such as bond, trust deed, syndicated loan, Mezzanine debt foreign bond, project finance and sale and leaseback etc, this study will look into the bank borrowing/ bank loan, bank overdraft and mezzanine debt followed by equity financing.

2.2 Bank borrowing/ bank loan

Bank borrowing is a way of borrowing money directly from the bank where there is no tradable security is issued. The firm than repays the bank with interest over time. The reasons as to why firms choose bank borrowing is that it cost low due to that there is no marketing expenses as the loan is negotiated directly with the bank. The procedure is quick and easy and also flexible in terms of negotiation if the economic circumstances of a company changes. However, on the other hand, there are other factors the firm needs to consider such as the cost that is involved in it, for example, the bank might request the borrower to pay an arrangement fee, normally a percentage of the loan. The borrower also needs to take into account the interest rate as it might be a fixed rate which could be high or floating rate which varies on a daily basis.

The bank might also be interested in the borrowers’ sincerity and capability to pay back the loan therefore might want to know why the loan is being taken out and thus will require detailed cash flow forecast. And, on the other hand, debt financiers mainly require security, which means they expect businesses to have some kind of evidence or assurance prior to they regard as making a loan for instance. (Watson & Head: 1998)

Join now!

2.3 Bank overdraft

Bank overdraft is the permit to overdraw on an account up to the permitted amount.

Overdrafts are usually arranged for limited period and the interest is charged for the days it has been overdrawn with. The reasons as to why the companies choose to overdraw are that it is easy to arrange and it is also cheap as the company/ borrower only pays for the days it used the overdraft. However, besides the advantages there is also a major disadvantage to the company as the bank could withdraw the overdraft agreement at a short notice and ...

This is a preview of the whole essay