Cost of Capital—Debt Financing

Sources of Long-Term Debt Financing

The following are sources of long-term debt financing:

• commercial loans from banks

• loans from large financial institutions (insurance companies, mutual funds)

• loans from specialist financing companies (equipment, accounts receivable, inventory, and so on)

• loans from private investors

• issuing company bonds (limited to larger, financially sound companies)

Below, we show the costs typically associated with long-term debt financing.

Debt Financing Costs

Types of Financing

Costs

Descriptions of Financing Costs

Interest payments Interest rate (prime + risk factor) times outstanding balance paid over life of debt)

Broker’s fee Finder’s and facilitator’s fees (paid up front)

Underwriting fees Assumption of issue risk by underwriter investment bank (paid up front)

Closing costs Miscellaneous package of expenses related to closing the deal (paid up front)

Professional fees Legal, tax, and accounting consulting fees (paid up front)

Miscellaneous expenses Costs of printing, recording, meetings, and so on (paid up front)

Below are the advantages and disadvantages of debt financing to the firm.

Advantages Disadvantages

1. The interest on loans is tax deductible.

1. The obligation to repay the loan increases the risk of bankruptcy.

2. Interest rates are normally lower

than for equity financing.

2. The firm incurs restrictive covenants and obligations.

3. The terms for principal repayment are often negotiable.

3. The firm must maintain the collateral requirements of secured loans.

4. Debt financing gives shareholders financial leverage.

4. Debt financing gives shareholders financial risk.

5. Shareholders’ equity is not diluted. 5. The firm incurs issuance costs.