Businesses often take advantage of debt when constructing capital structure, as actually it can help lower the total cost of financing. In addition to this, it has other advantages compared with having equity financing, despite the known issues that it comes with ongoing financial liabilities and even the potential risk of bankruptcy. Specifically, here are the benefits you can get from using debt for the capital structure of your business:
When your company uses debt to put in additional capital for its operations, you will get to keep any extra profits that are going to be generated by the debt capital after any payments of interest. Given the same amount of equity investments, you (as an equity investor) will have a higher return on equity from the extra profits brought about by the debt capital. As long as it does not threaten the financial soundness of your company during difficult times, you can certainly use debt to help enhance your investment returns.
Debt requires lower financing cost compared to equity, which means that you can often mix debt into your capital structure to lessen your average financing cost. As you will be contractually liable to make periodic interest payments and to return the debt principal when it matures, you will bear less risk compared to equity holders, who often have no resort for their investments if their ventures fail. When it comes to company liquidation, you will also have the senior claiming rights to company assets, giving you another layer of protection for your investments.
Debt can help you lower your business taxes because of the allowable interest deductions. You see, tax regulations will permit your interest payments as expense deductions against your revenues to arrive at your taxable income, so the lower your taxable income, the lesser you will be paying for taxes. Unlike dividends, which are paid to equity holders, they are not tax-deductible and come from after-tax income. Thus, it will lower your debt financing cost, which is lacking in equity financing.
Though debt would add pressure to your ongoing operations as you will have to meet interest-payment obligations, it can help you retain more profits compared with using equity, which requires company profit sharing with equity holders. Using debt, you will just need to only pay the amount of interest out of your profits.