QUESTION THREE Debt finance is another common source of capital for companies. D
ID: 2814664 • Letter: Q
Question
QUESTION THREE
Debt finance is another common source of capital for companies.
Discuss three forms of debt instruments that are available to companies contracting debt finance. (7 marks)
In relation to a company sourcing capital discuss three benefits and short comings of debt finance and contrast these with those of equity finance.
(6 marks)
b) A plant requires the use of 200,000 units of a component for its production. The cost to the company is K5000 per unit. The cost per order is K80, 000 and the carrying cost per unit as percentage of unit cost is 10%.
Determine the economical quantity to order using the EOQ model.(3 marks)
What is the Total ordering Cost to the company? (2 marks)
What is the Total Carrying cost to the company? (2 marks)
Explanation / Answer
Three forms of debt finance to companies are as follows:
1. Issuing of bond: Companies issue bond to get money for its day to day business.
2. loan: companies take loans from bank and do business on these money.
3. Lease: in this companies make periodic payment for the land where it is operating.
Benefits and shortcoming of debt financing:
1. Shareholders will not lose the ownership.
2. Cost of debt is less in comparision ot cost of equity.
3. Leverage effect can multiply the performance of companies in both side, if company is doing very good then ROE will be very large due to leverege effect similarly if company faces challenges with reveunue then ifs net profit will fall further due to interest expense that will again lead to bankruptcy of the organisation.
4. Debt fianancing can be very costly if the companies credit status is bad.
5. Debt financing is time bound activity, in which borrower has to payback on the mentioned time even its business is not performing.
6. Debt financing has first claim on failed company's asset.
In equity finacing there is loss of ownership but in debt financing there is no loss of ownership but debt financing has first say in case of bankruptcy that menas if company fails then debt financier will have first claim on company's residual asset. If there will be anything remeainng afterward then eqiuty financer can claim.
EOQ = root(2*S*D/H)
where S = K80000
D = 200000 units
H = 10% of K5000 = K500
EOQ = 8000 units
Total ordering cost = D/EOQ * S = 200000/8000 * 80000 = K2,000,000
Total carrying cost = EOQ/2 * H = 8000/2 * 500 = K2,000,000