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Is it good to use Debt in Firm or Bad, Is there any social aspect of using Loan in Firm?

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Question added by Anayatullah Tahir , Finance Manager , Etqan Projects
Date Posted: 2014/09/11
Deleted user
by Deleted user

Introduction of debt in the capital structure of the comapny increases risk. Besides being risky debts are an important source of finance specially when business entity is having profitable investment projects but not enough funds to fnance them. Debts also have advantage that they are tax deductible. 

Anayatullah Tahir
by Anayatullah Tahir , Finance Manager , Etqan Projects

Firm's Position:

Using debt in firm's capital structure reduces taxable income, and in return greater ROE (Return on Equity), Debt holders get interest and government gets taxes. All the finance books say it and the story is finished. Lets see it the situation from a defferent angle. As an example, an all-equity firm pays taxes $100 and rest of the earnings belong to shareholders, whereas a firm having debt in capial structure pays interest $40, the taxable income will be reduced and the firm will pay $40 as taxes to government. In this case the firm paid40+40=80 to oursiders and the rest is for shareholders. Econonmically thinking the company is better off, it paid total as80 as opposed to100.

 

Government Position:

The finance books are quite on the government collections.

What happned to government, it was going to receive100 but received only40 as taxes from the firm, is there any other profit for the government? yes. Investors of debt which received40 as interest from the firm will be taxed by government on this interest income, but that will be20 to30 percent of the interest income40X30%=12, so still governement will receive as a total40+12=52, which is much less than100. Government receipts (taxes, Zakat etc) are people's money, government will spend that money to general public. But the interest received by the debt holders, is their own earning they are not going to spend that to public. Simply then government and people of the country are going poor (because less facilities offered by governement for medical, education, energy etc), but debt holders (capital holders, big shots) are every increasing in their wealth.

Why government decides then to be poor and keeps debt holders rich? this is called capitalism.

 

Debt Holders' Position:

Debt holders enjoy following benefits like:

  • Low risk return (return on debt is fixed)
  • Ever increasing wealth (the return on debt is less than from shareholders but still it is so much more than inflation rate that they are much more happy).. Equal distribution of wealth is not possible in this case
  • Perfomance of firm (they dont have to worry about they firm's performance, profitable or otherwise, they are guaranteed with return) giving rise to greed without considering social impact of failing firms to the society

The list goes on and on, therefore the idea of Debt capital in the firm, overall is anti-social.

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