Long Term Debt Finance, Features, Advantages and Disadvantages

Features

  • Debt securities are fixed income securities.
  • Interest on debt is an allowable deduction for tax purposes.
  • It is usually secured.
  • It’s provided with conditions.
  • It can be raised faster than ordinary share capital
  • It increases the firm’s gearing and financial risk.
  • Provides of this capital do not participate in the firm’s supernormal earnings.
  • Providers of this capital do not have ownership and voting rights.
  • Interest is paid in priority to ordinary share dividend.
  • Providers of this capital have a priority claim on the company’s asset in the event of liquidation.
  • It is redeemable.
  • The firm is under legal obligation to pay interest.
  • It involves lower floatation costs when compared to ordinary share capital.
  • It is not accessible to all firms.
  • It can only be applied in projects which have been approved the lenders.

 

Advantages (From the Borrowers Point of View)

  1. Interest on debt is an allowable deduction for tax purposes.

Use of debt finance therefore provides the company with tax savings.

  1. It does not involve dilution of ownership and control of the firm the existing shareholder.

This is because providers of this capital do not get ownership and voting rights.

  1. Providers of this capital do not participate in the supernormal earnings of the firm.
  2. Payment to them is limited to the amount of interest.
  3. It involves lower floatation costs when compared to ordinary share capital.
  4. It does not lead to dilution of the firms earnings per share.
  5. It can be raised faster than ordinary share capital.
  6. The process of raising this capital does not involve a lot of formalities.
  7. The cost of servicing this capital i.e. interest is not experienced the company perpetually. This is because debt securities are redeemable.
  8. Use of long term debt finance is beneficial to the company during periods when market interest rates are raising.
  9. During periods of high initiation the company benefits from debt because the obligation to remain fixed but decline in value.

 

Disadvantages

  1. The company is under legal obligation to pay interest. Non-payment of the interest may lead to liquidation of the company.
  2. It is provided with conditions regarding its use. It’s therefore not a flexible source of
  3. It is usually secured. The company must have sufficient assets to pledge as collateral for the loan.
  4. It increases the company’s gearing and financial risk.
  5. Use of long term debt is disadvantageous to the company during periods when market interest rates are falling. The firm is locked into a high fixed rate of interest and does not benefit from the falling market interest rates.
  6. It is not accessible to all the companies. It can only be raised financially sound companies which are well-known to the lenders.
  7. Redemption of this capital involves huge out flow of cash. Such outflow may leave the company being financial constraints.
  8. Providers of this capital are entitled to interest and claim on the company’s assets in priority to the ordinary shareholders.
  9. The lenders may insist that the assets pledged as collateral security should be fully insured and well maintained. These are additional implied costs.
  10. Protective covenants contained in the loan agreement deeds may limit the firms operating flexibility.
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