A:

It is easy to conceptualize when a business should avoid debt financing, such as whenever debt results in excessive future risk or when equity financing offers greater expected future value. The practical process of evaluating financing risk or reward is much more difficult. As a general rule, the maximum total debt financing for a business is limited by the owners' equity, the business's liquidity, or cash flow, and relative cost of capital.

Debt financing almost always costs less than equity financing. Equity ownership is risky, so the premium charged by possible equity investors tends to be quite high. The only exception is when a business is so overleveraged that creditors do not offer competitive rates. The temptation to use a lot of debt financing needs to be counterbalanced by business discipline and understanding.

Debt Repayment

Business debt is like personal debt; it needs to be paid back with future income. Just as no individual should borrow more than he can reasonably repay in the future, no business should borrow more than its expected future earnings.

Debt burdens can be estimated using accounting ratios, such as the debt-to-equity ratio. This ratio divides total debt obligations by owners' equity. The higher the number, the more indebted the firm and the more risky future debt financing becomes.

At a minimum, companies should have more operating income than interest payable on debt. Businesses that have more total debt payments than profits are likely to struggle or even declare bankruptcy.

According to the tradeoff theory of capital financing, the optimal level of debt financing for a business is determined by the balance between the tax benefits of debt, as interest payments are tax deductible, and the costs of potential bankruptcy, including higher borrowing costs.

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