Re: Capital Formation
Capital formation falls under the broader foundation of capital structure and it basically involves
the decision to issue either preference shares, equity shares or other long term debts in the form
of direct loans from banks, debentures or other forms of raising finance in the financial market
(Baker, 2015).
The use of debt instruments to finance capital formation makes a firm risky to the ordinary
common stockholders. When a firm acquires debt (Financial leverage) it takes additional
responsibility of paying also interest that is chargeable as the cost of capital. The inability of a
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company to pay the principal or the interest may lead to bankruptcy. The chances of default on
debts increases with the amount of debt acquired.
Financial leverage increases the expected returns by shareholders but it raises the volatility of the
expected returns.
The major advantage of debt capital is that the interest payable is a deductible expense on a
company’s tax returns hence debts facilitates lower tax payments. Unlike capital formation from
debt equity capital does not attract any special tax treatment and no tax advantages may accrue to
a company when it uses equity capital to fund the company’s operations (Baker, 2015).
According to Modigliani-Miller (1958) concepts, an environment that includes corporate taxes, a
company enjoys benefits of utilizing debt as an interest tax shield. The value of a company
increases when the level of debt capital increases. A company earns some savings from using
debt and which outweigh the ultimate costs of using equity (Gitman, 2011). The average
weighted average cost of capital that a firm faces decreases ultimately with increased usage of
debt. Debt is basically a cheaper source of financing for companies compared to equity and the
interest payments are tax deductibles. For non-liquidations, debt capital is repaid before the
ordinary shares are compensated.
Capital formation from debt does not dilute the shareholder’s ownership of the company as the
lenders have no claim on the company’s equity. The lenders claim in the company is restricted
to the interest payable and no they have no claim on the company’s future profits. Debt financing
allows the company to plan and forecast on how the debt would be repaid as the obligations are
clear and predictable (Gitman, 2011).
Raising debt capital is convenient and less complicated that equity capital that requires the
consent and compliance of federal securities laws.
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The major disadvantages of debt capital as compared to equity is that debt capital must be repaid
back including the cost of finance unlike equity capital that is not repayable. The high interest
payments increase the cost of products and also the breakeven costs. Highly levered companies
face limited growth prospects because of the high costs of servicing debts.
Debt instruments unlike equity capital face restrictions on various company activities that may
not allow them to implement alternative financing options in future (Baker, 2015).
Most financial institutions require companies to pledge specific assets as collateral against any
loans that are extended or advanced to the company. It is normal for banks or other financial
institutions to place some lien on certain assets that cannot be sold (Doupnik and Hector, 2012).
To conclude, equity and debt are the two major types of capital that investors can fund a
business. When capital is raised through equity, a company offers its shares to investors in
exchange of cash. The shares or stock exchanged basically represent ownership of the business.
Debt financing refers to capital formation by use of debt instruments like debentures or corporate
bonds. Capital formation from debt frees the company from unnecessary controls that attracts
equity capital where the shareholders also seek to voice their concerns and opinions on
management issues. Debt financing frees a company from inconveniences that characterizes
equity capital and a world of opportunities can be explored as debt capital can be easily arranged
when a company enjoys good credit rating.
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References
Baker, P., (2015) Understanding Financial Management. 2nd ed. Oxford: Blackwell Publishing.
Gitman, J., (2011) Principles of Managerial Finance. 6th ed. French’s Forest: Pearson Australia.
Doupnik, T. S, and Hector B. P. (2012) International Accounting. New York: McGraw-Hill Irwin, 2012.
Print
Modiglini, F. and Miller, M. (1958) “The Cost of Capital, Corporation Finance and the Theory of
Investment,” American Economic Review, 53 (June 1958), 261-297.
