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.“The problem is how to motivate managers to disgorge the cash rather than investing it below...

.“The problem is how to motivate managers to disgorge the cash rather than investing it below the cost of capital or wasting it on organizational inefficiencies’. Explain how debt finance can provide a solution to this problem.

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Answer #1

In general market conditions, the cost of equity is higher than that of cost of debt. The main reason behind such higher cost of equity is the higher risk involved in the equity instruments.

So, the cost of capital of the company is higher than the cost of debt. This means that the company can obtain finance at lower cost and invest and earn in its business at higher rate of return of equity.

This strategy is very simple and beneficial when cost of debt is lower than the cost of capital. And the company can preserve its surpus equity in higher beneficial investment projects.

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