Identify several factors that influence the decision to issue debt

Question

What will be an ideal response?

Answer 1

Financial Flexibility When a firm needs to raise additional funds, its bargaining position is better if it has options or
choices.
Credit Rating Dropping a notch in the rating system leads to an increase in the firm's borrowing costs, so managers
like to avoid this problem if at all possible.
Insufficient Internal Funds It has long been known that firms tend to follow a priority list when raising new funds that
has been referred to as a "pecking order." The order in which firms typically finance their operations begins with
internally generated profits, followed by debt financing, and, finally, by issuing new equity.
Level of Interest Rates Other things being the same, firms prefer to borrow when they feel interest rates are low
relative to their expectations.
Interest Tax Savings Interest expense, unlike dividends paid to shareholders, is a tax-deductible expense. This
tax-savings feature serves as a subsidy to corporate borrowing and makes debt appear cheap relative to alternative
sources of financing.
Transaction Costs and Fees When a firm chooses between debt and equity, it faces very different costs of issuing the
two types of securities. The differentially higher costs of issuing equity make it less attractive as a source of financing.
Equity Undervaluation/Overvaluation Earlier we mentioned that CFOs often try to time their debt offerings to take
advantage of abnormally low interest rates. The same holds true for equity offerings.
Comparable Firm Debt Levels Firms in similar businesses tend to have similar capital structures. This is made doubly
important by virtue of the fact that lenders and credit rating agencies often compare a firm's debt ratios to those of
comparable firms when deciding credit terms and ratings.
Bankruptcy/Distress Costs The more debt a firm has used in the past, the higher the likelihood is that the firm will at
some point face financial distress and possibly fail. This risk forms the basis for the firm's credit rating.
Customer/Supplier Discomfort An important source of financial distress brought on by the use of debt financing
comes in the form of pressures from both the firm's customers (who fear that financial distress may interrupt their
source of supply) and the firm's suppliers (who fear that financial distress may interrupt an important source of
demand for their goods and services). The latter is compounded further if the supplier has provided the firm with
trade credit, which is at risk if the firm fails.