Chapter 15 notes

Question 1

What are the pros of using debt? (need to know 2 for the test)

Answer 1

1) Interest payments are tax deductible
2) The financial obligation is clearly specified and fixed in nature - re: the principal amount, maturity date, contract rate and frequency of payment
3) In an inflationary economy debt may be paid back with cheaper dollars with declining purchasing power.
4) It may lower the WACC with its low after-tax % cost

Question 2

What are the disadvantages of using debt (need to know 2 for the test)

Answer 2

1) Interest and principal payment obligations are set by contract and must be met regardless of the economic position of the firm.
2) Bond indenture agreements may place burdensome restrictions on the firm to maintain financing ratios - bondholders may take virtual control of the firm if important indenture provisions are not met.
3) Utilized beyond a given point, debt may depress the market values of common stock as the use of debt has increased the risk of the firm.