What is the advantage of external commercial borrowings?

Answer 1

Advantages:

As long as the company's return on invested capital is higher than the cost of borrowing, it is advantageous for the company to borrow. the advantages include the tax shield, as muncie birder mentioned, and more importantly, the effect of financial leverage. remember the definition of the word leverage. it's like having a multiplier effect. a borrower who's return on capital is higher than the interest rate on the debt is basically using other people's money to produce returns for themselves.

another advantage of borrowing is that it does not dilute the value of shareholders' equity by adding to the number of shares outstanding.

disadvantages are the increase in default risk, bankruptcy risk, and a plethora of interest rate and market risks related to having more debt on a company's balance sheet. having more debt may increase your actual cost of borrowing, ie. the intrest rate paid on the debt. with public companies, the ratings agencies will see the additional debt burden and possibly lower the company's rating, which automatically boosts borrowing costs. this could have a downward spiraling effect on the company as its borrowing costs go up, but suddenly less capital is available to draw from due to the lower credit rating. in the case of a liquidity crunch, this can dramatically increase the risk of bankruptcy.

other disadvantages include the effect on earnings due to interest expense payments. public companies are run to maximize earnings. private companies are run to minimize taxes, so the debt tax shield is less important to public companies b/c earnings still go down.

another advantage of borrowing is that it is a way of rasing capital without giving away any control, as debt holders don't have voting rights, etc.

debt may also be a more easily hedged form of raising capital, as swaps and futures can be used to manage interest rate risk.