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Doubt on debt/ equity

shwetha (CWA learner) (447 Points)

22 November 2011

For a company having more debt is good or having more equity is good ? pls explain in detail.

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(Guest)

A Co. having debt is good, bcz it means co. is growing thats why they need more fund for expension.

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shwetha (CWA learner) (447 Points)
Replied 22 November 2011

Khanna.....

Having more equity also we can apply same concept know. actually my doubt is ....... debt means getting fund from outsiders and equity means getting fund from shareholders. how can debt become good?

Spending debt money on fixed assets is good? orelse spending equity money on fixed assets is good?

sripal (article) (68 Points)
Replied 23 November 2011

proportion of debt or equity depends upon the rate of return the company earns. there's a simple concept called leverage.

suppose the rate of return on investments in higher than the cost of debt then more of debt in beneficial.

following illustration will help you.

Attached File : 510169 872339 doc1.pdf downloaded: 202 times

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Roshan A (Chartered Accountant) (458 Points)
Replied 23 November 2011

Originally posted by : sripal
	proportion of debt or equity depends upon the rate of return the company earns. there's a simple concept called leverage. suppose the rate of return on investments in higher than the cost of debt then more of debt in beneficial.

A precise and proper explanation...Agreed!!!!

sivaram (Asst Mgr-Taxation) (6918 Points)
Replied 23 November 2011

Dear Students

Is this Return on Investment as explained by sripal is the return on equity i.e the expectation of shareholders or it implies any thing else?

Can any one make me understand that so that this concept gets digested in my muddy brain

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Nagam saisameer (CA FINAL ) (170 Points)
Replied 23 November 2011

Normally Having Debt is cheaper than equity beacuse debt can be is repaid with certain Interest whereas equity is more cost since, the expectations of share holders are high from the profits.

Thanks and Regards

Roshan A (Chartered Accountant) (458 Points)
Replied 23 November 2011

Sir

ROI is what COMPANY is expecting to earn on its investment & not what shareholder is expecting from the company(by investing in the company)....Shareholders expectataion is Cost of equity for the company...Hope u understood it

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sivaram (Asst Mgr-Taxation) (6918 Points)
Replied 23 November 2011

Mr Roshan Thanks

But May I know is this return an expectation ? or any formula to work out return on investment by a company say 15% on trend 1 in the example and 25% on trend 2 in example given by sripal? can u explain if possible

Roshan A (Chartered Accountant) (458 Points)
Replied 23 November 2011

Yes the formula for calculating ROI is EBIT / TOTAL CAPITAL ,

EBIT=SALES-(Variable+Fixed Cost)

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sivaram (Asst Mgr-Taxation) (6918 Points)
Replied 23 November 2011

Many Thanks Roshan I really learnt something today

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Phalgun (Audit Manager) (327 Points)
Replied 23 November 2011

For any company both debt & equity has to be balanced. Having more debt leads to financial risk. Having more equity leads to over capitalisation. To have Financial leverage one needs to blend both in a proper ratio. For which a good financial manager is required to analyse & act upon.6

CA Arun Chhajer (GST Faculty @ Ministry of MSME Govt of India) (2813 Points)
Replied 23 November 2011

Hi,

To answer the main question......As one frnd rightly said Debt is cheaper than equity hence company should raise fund from Debt as well to take the benefit of leverage. As there are two benefit on Debt -

1) Less rate of Interest and

2) Tax Deductible Expenses ( means allowable expenses while calculating Tax)

Further company should also take into account the Debt Equity Ratio ( Formula DEbt / Equity), which ideally should not be more than 2:1. Higher the ration high risk for the company.

Regards

Arun