Features
- Debt securities are fixed income securities.
- Interest on debt is an allowable deduction for tax purposes.
- It is usually secured.
- It’s provided with conditions.
- It can be raised faster than ordinary share capital
- It increases the firm’s gearing and financial risk.
- Provides of this capital do not participate in the firm’s supernormal earnings.
- Providers of this capital do not have ownership and voting rights.
- Interest is paid in priority to ordinary share dividend.
- Providers of this capital have a priority claim on the company’s asset in the event of liquidation.
- It is redeemable.
- The firm is under legal obligation to pay interest.
- It involves lower floatation costs when compared to ordinary share capital.
- It is not accessible to all firms.
- It can only be applied in projects which have been approved by the lenders.
Advantages (From the Borrowers Point of View)
- Interest on debt is an allowable deduction for tax purposes.
Use of debt finance therefore provides the company with tax savings.
- It does not involve dilution of ownership and control of the firm by the existing shareholder.
This is because providers of this capital do not get ownership and voting rights.
- Providers of this capital do not participate in the supernormal earnings of the firm.
- Payment to them is limited to the amount of interest.
- It involves lower floatation costs when compared to ordinary share capital.
- It does not lead to dilution of the firms earnings per share.
- It can be raised faster than ordinary share capital.
- The process of raising this capital does not involve a lot of formalities.
- The cost of servicing this capital i.e. interest is not experienced by the company perpetually. This is because debt securities are redeemable.
- Use of long term debt finance is beneficial to the company during periods when market interest rates are raising.
- During periods of high initiation the company benefits from debt because the obligation to remain fixed but decline in value.
Disadvantages
- The company is under legal obligation to pay interest. Non-payment of the interest may lead to liquidation of the company.
- It is provided with conditions regarding its use. It’s therefore not a flexible source of
- It is usually secured. The company must have sufficient assets to pledge as collateral for the loan.
- It increases the company’s gearing and financial risk.
- Use of long term debt is disadvantageous to the company during periods when market interest rates are falling. The firm is locked into a high fixed rate of interest and does not benefit from the falling market interest rates.
- It is not accessible to all the companies. It can only be raised by financially sound companies which are well-known to the lenders.
- Redemption of this capital involves huge out flow of cash. Such outflow may leave the company being financial constraints.
- Providers of this capital are entitled to interest and claim on the company’s assets in priority to the ordinary shareholders.
- The lenders may insist that the assets pledged as collateral security should be fully insured and well maintained. These are additional implied costs.
- Protective covenants contained in the loan agreement deeds may limit the firms operating flexibility.
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