Why use debt over cash?
for a project, why would a company choose to use debt over cash to finance a new project even though they have enough cash on hand.
My answer so far: 1) debt magnifies returns 2) Company might want to have more cash on hand just in case
Debt is very cheap right now as well as offer a tax shield from the interest write offs. By using cash, they are adjusting their operational leverage which means they may not have enough cash to sustain business operations should something happen to the company that would reduce cash flows. ex. O&G company experiencing a down cycle in the price of oil
Also, by using debt it increases their leverage which may allow the company to grow at a faster rate vs. just using cash while not bringing the company to an unhealthy level of debt.
Think about buying a rental property with cash, your returns are going to be a lot lower vs. if you used a mortgage that you could easily support with the rent payments and your day-to-day job income should something happen.
How does the tax shield play into this? I understand debt is tax deductible, but even with the deductions, cash will still be cheaper than debt right? Or is that statement not always true?
Tax shield effectively reduces the cost of debt. However, I think where your getting confused is the idea that you need to attribute a 'cost' to cash. Even though your not paying interest on it, there is an opportunity cost to holding cash in your bank account. For example, if you had debt at 5% you could realize an immediate ~5% return on your cash by paying off the debt.
Say mortgage rates are 3% and after tax cost of 2.5%, your rental property earns 10% cash-on-cash it makes sense to use the cheap cost of debt and use your cash to fund other projects where you can earn higher rates of return above the 2.5%.
Isn't the cost of cash the potential you could earn on cash interest? Like a savings account for corporations (not sure if that exists) My question is, does the debt tax shield ever reduce the cost of debt below the cost of cash?
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