Chapter 5: Q17DQ (page 524)

Question: Discuss the advantages and disadvantages of debt

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Answer

The advantages are tax-deductible interest payments, clearly specified financial obligations, and help in lowering the overall cost of capital.

Disadvantages are Interest payments and repayments are required to have to be met, indenture agreements and excessive use of debt.

Step by step solution

The advantages of debt are as follows:

Interest payments are tax-deductible: Any interest payment on debts is tax-deductible which helps in saving lots of money as the maximum tax rate is in the mid-30s.
Clearly specified financial obligation: The financial obligation of the debt is very clearly specified and is of fixed nature.
Cheap repayment: In the case of inflation in the economy, it can be repaid with cheaper dollars.
Helps in lowering the cost of capital: Use of debt by the companies to a certain may also help them in reducing the cost of capital of the business.

The disadvantages of debt are as follows:

Interest payment and repayment of the principal amount are set by a contract and must be met.
Indenture agreements sometimes put pressure on the companies.
Utilization of debt beyond the limit sometimes may depress the value of the common stock of the company

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Bailey corporation
Income statement
For the year 20X1
Sales (all on credit)	\(42,680,000
Cost of goods sold	\)32,240,000
Gross profit	\(10,440,000
Selling and administrative expenses	\)4,558,000
Operating profit	\(5,882,000
Interest expense	\)600,000
Net income before taxes	\(5,282,000
Taxes	\)2,120,000
Net income	\(3,162,000

Bailey corporation
Balance sheet
As of December 31, 20X1
Assets
Current assets:
Cash	\)250,000
Marketable securities	\(130,000
Accounts receivables	\)6,000,000
Inventory	\(8,300,000
Total current assets	\)14,680,000
Net plant and equipment	\(13,970,000
Total assets	\)28,650,000
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	\(3,800,000
Notes payable	\)3,550,000
Total current liabilities	\(7,350,000
Long-term liabilities	\)5,620,000
Total liabilities	\(12,970,000
Stockholder’s equity:
Common stock (1,800,000 shares at \)1 par)	\(1,800,000
Capital in excess of par	\)6,300,000
Retained earnings	\(7,580,000
Total stockholder’s equity	\)15,680,000
Total liabilities and stockholder’s equity	$28,650,000