Why Do Companies Prefer Long-Term Debt?

A company has an option to fund operations using its own cash or Long-Term Loans. Corporations can tap the capital market segments by issuing stock to shareholders to improve money or issue commercial bonds. These decisions relate to a company’s capital structure, or the mix between debt and equity. A company may prefer long-term debt as a result of tax deduction on interest repayments, but it depends upon the company’s corporate and business finance insurance policy; too much personal debt boosts default risk.

Long-term Debt

Long Term Loans has a definite advantage over equity financing due to a deduction companies obtain for interest obligations. If a company’s long-term borrowing cost is 9 percent and its own tax rate is 31 percent, its effective borrowing cost is 9 percent multiplied by 1 minus its tax rate, which equals 6.2 percent. Companies have a motivation to borrow money for that reason tax benefits. However, in most cases of thumb, a company should only use long-term personal debt to fund jobs offering a profit on return above its borrowing costs. For example, if the business tasks that new equipment will probably raise productivity and earn a 15 percent return on the investment, then borrowing money at a highly effective interest rate of 6.2 percent is worth the investment.Read more.

Debt Ratios

Corporate professionals, lenders and investors use debt ratios to ascertain whether the company is over-leveraged. A higher debt ratio implies that the company relies too greatly on debt and can spell trouble. Common debts ratios are the debt-to-equity percentage, debt-to-total resources, or debt percentage, and interest coverage ratio, which is cash flow before interest and fees divided by interest expense. A corporation may prefer to use Long Term Loans but faces the opportunity of increasing the company’s default risk, as evidenced by the business’s debt ratios.

Capital Structure

A company’s capital structure is of importance to management, lenders and shareholders. Capital structure refers to what sort of company chooses to invest in itself to preserve operations. A business can choose to invest in businesses using no arrears and all collateral or a combination of both. 

  • The key is finding the optimal capital composition and buying projects that provide a go back above the business’s cost of capital. Quite simply, even though interest payments are tax deductible, the company must find the appropriate balance of debts and collateral without skewing its debt ratios. 
  • It is not unusual for lenders to enforce debt covenants, which can be financial, operational guidelines that assure lenders will get their money back. Examples of Long Term Loansinclude maintenance of bare minimum working capital requirements, constraints on borrowings and maintenance of online worth.

Weighted Average Cost of Capital

It is unrealistic and high-risk for a corporation to work with all debts to funding its functions. In corporate finance, the concentrate is on the full total cost of borrowing including debts and collateral. The weight-average cost of capital, or WACC, is the formulation used to analyze a company’s total cost of borrowing. The method for WACC is required, return of debt financing multiplied by 1, without the tax rate multiplied by the percentage of Long Term Loans to the total value of the company, plus the expense of equity multiplied by the ratio of equity to total company value.