Why is debt an attractive source of capital? What risks does a company incur when it uses debt to fund growth? Why will a company that uses 10% debt have less variability in EPS at different levels of income than a company that uses 25% debt? At what cost of debt will there be no difference in EPS at a given level of income?

Why is debt an attractive source of capital? What risks does a company incur when it uses debt to fund growth? Why will a company that uses 10% debt have less variability in EPS at different levels of income than a company that uses 25% debt? At what cost of debt will there be no difference in EPS at a given level of income?
Debt finance is more attractive than equity finance because the costs of raising the funds such as the arrangement fees with a bank or issue costs of a bond is lower. The annual return required to attract investors is also less than for equity because investors recognize that investing in a firm via debt finance is less risky than investing via shares. It is less risky because interest is paid out before dividends are paid. Therefore, there is greater certainty of receiving a return than there would be for equity holders. Also, if the company goes into liquidation, the holders of a debt type of financial security are paid before shareholders receive anything. In addition, when a company pays interest, the tax authorities regard this as a cost of doing business, and therefore, it can be used to reduce the taxable profit. This lowers the effective cost to the company of servicing the debt compared with servicing equity capital through dividends which are not tax deductible. In addition, the company's shareholders can maintain ownership of the business.

What risks does a company incur when it uses debt to fund growth?
By using debt to fund growth, the company has made the commitment to make interest payment to the creditors under a fixed schedule and interest rate. They are the risks for the company because creditors are often able to claim some or all of the assets of the company in the event of non-compliance with the terms of the loan. This may result in company's liquidation.

Why will a company that uses 10% debt have less variability in EPS at different levels of income than a company that uses 25% debt?
A company that uses 10% debt will have less variability in EPS at different levels of income than a company that uses 25% debt because of financial leverage. Financial leverage is the degree to which the company is utilizing borrowed money. The company that are highly leveraged or has higher debt portion will have higher risk of bankruptcy. However, financial leverage can increase the shareholders' return on investment in the form of EPS due to tax deductibility from the borrowing.

At what cost of debt will there be no difference in EPS at a given level of income?
If we assume a given level of income of $100,000, total number of shares of 10,000, cost of debt, tax rate of 40%, and 10% debt and 25% debt in the capital structure, then we use different cost of debt ranging from 0% to 10%. We can see that at 0% cost of debt there will be no difference in EPS at a given level of income. With 10% debt in the capital structure, the increase in the cost of capital by 1% will decrease the EPS by approximately 0.1% while the increase in the cost of capital by 1% will decrease the EPS for 25% debt in the capital structure at a higher rate by approximately 0.25%. In addition, the difference between the EPS of 10% and 25% debt in the capital structure increases as the cost of debt increases.

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