Issue Brief: Why Businesses Use Debt

The following examples are drawn from Dr. Rebel Cole’s “Why Businesses Use Debt – And How Businesses Benefit From Debt.”

Private business

Chez José is a small restaurant owned by its proprietor—José Smith. Last week, José learned that he needs a new roof on his building, and that this will cost him $10,000. Unfortunately, José only has $5,000 in savings. Because his business is a proprietorship, José cannot obtain additional equity from outside equity investors, so his only real option is to borrow the needed funds from a bank. A bank loan is the most common form of business debt. In this situation, if José cannot obtain debt financing, he will not be able to fix his roof; instead, he would have to shut down his company and lay off his employees.

Public company

Koala Corp is a public traded company that is seeking to expand its operations by adding new machinery. As a public company, Koala Corp could engage in a secondary equity offering, selling new shares to outside investors. However, selling new shares will dilute the ownership of existing investors, reducing their cash-flow and control rights. There also are large fixed underwriting costs associated with selling new shares that must be paid to investment bankers.

As an alternative to issuing new shares, Koala Corp can follow the example of Chez José and borrow the needed funds from a bank; or Koala can tap the public debt markets by issuing a corporate bond. In addition to avoiding the underwriting costs and dilution of shareholders, a company can obtain debt at a lower cost than equity because of the senior payment status of lenders relative to shareholders. For all of these reasons, even a publicly traded company like Koala Corp often prefers to finance new assets with debt rather than with equity.

Impact of Limiting Interest Deductibility

Eliminating or limiting interest deductibility would raise the costs of capital on both Chez José and Koala Corp. Higher costs will lead to less investment in their businesses whether it’s less new machinery for Koala Corp or less capital for José Smith to upgrade the restaurant, hire another chef, or invest in new food items. These costs do not just impact the owners of those businesses, but their employees and customers.

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