Advantages of Leveraged Financing

Leveraged financing is cheap and quick.

Many firms strive to reduce the costs of doing their business and maximize their profits. Managers must be innovative in this pursuit while remaining competitive. This has led to managers first wanting to expand the business. It is through expansion that the firm is able to achieve economies of scale. Since capital is scarce, firms often borrow funds to meet their expansion needs. Leveraged financing is the use of loans by companies to finance their operations. Companies use it to expand operations and finance new projects.

Tax Saving

The price of borrowed funds is interest. This is an expense to the borrowing party. Firms report expenses as deductions in the profit and loss account. Since equity capital does not attract interest, a firm that only uses equity financing pays a higher tax than a company using debt financing. This is because the interest the loan attracts reduces the reported profits, reducing tax.

Cheaper and Faster

Firms incur very high costs trying to raise capital by issuing shares due to the high flotation costs involved. On the contrary, firms incur less cost by using borrowed funds since they do not have to incur the costs associated with issuing shares. In addition, the process of issuing shares is quite long, therefore in order to raise funds urgently; the firm will opt for debt financing since processing of loans takes a short time.

More Funds

Firms can only issue equity capital up to a certain limit beyond which it would be uneconomical to raise funds for expansion. This is because the issuance of equity capital is costly due to the high flotation costs. The more the equity capital, the higher the flotation cost. In addition, issuing equity capital dilutes the company’s ownership. The firm can raise more funds from debt than from equity as long as the financial institution advancing the loan sees the borrower as being able to pay. This is because when the company has highly valued assets, it is able to use them as collateral for borrowing funds. Banks also finance projects which also act as the security for the loan themselves.

Maintain Control

When a firm borrows funds, the lender does not gain control of any part of the firm. Whey a company issues shares, it dilutes ownership of the company. Leveraged financing enables the company to avoid this dilution.

References

• “Leverage: The Key to Multiplying Money”; Gerald Krefetz; 1986
• “Capital Structure & Corporate Financing Decisions: Theory, Evidence, and practice”; H. Kent Baker, Gerald S. Martin; 2011
• “Subcommittee Prints”; United States Congress House Committee on Veterans’ Affairs, Et Al; 1970
• “Finance & Accounting for Non-Financial Managers”; Samuel C. Weaver, J. Fred Weston; 2004