It is always said equity has highest cost of funds, question remains this is thumb rule for all situation.

Debt is raised at lower cost as it will be raised by providing some security and fixed cashflow obligation. In addition to the lower cost of funds businessmen not account for fixed cashflow obligation for all business situations. For eg. Mr. A starts business in good market conditions and goes for debt for the reason market is good and he can easily flourish into the market. If market condtions work well for him he will flourish more than even he thought and he is able to leverage benefit by taking the low cost debt.

Same mr. A takes loan for same business; For some economic reasons if his business is not picking up as per his projections of cashflows. Obligations remains same, one needs to honour this obligation as well irrespective of his business conditions. He might end up being defaulter or he needs to put money from his own kitty for survival.

What if mr. A shared business opportunity with someone by sharing equity?? Situation 1: Market is performing good he is losing some of benefit in best case scenario; as profit share in equity terms will be less as compared to raising debt, but no question of loss. Situation 2: Market is not good; here one understands the benefit of shared risks. He need not be worried as to cashflow obligations and in case of own infusion requirement he got two promoter sources.

Best idea to arrive at cost of funds and structure suitability is making cashflow projections and checking it with difference scenarios which will enable promoters to arrive at conclusion as to what is more; cost of funds or cost of shutting down the business.

 

 

Also read related article: How to Pay Zero Tax for Income up to Rs 10 Lakhs by CA Chirag Chauhan

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article author CA Nikesh Sheth
Posted On:  1 year ago

Hi , Nice article


article author

CA Chirag Chauhan

Tax Expert
Chartered Accountant, CA Chauhan



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