Question

You are advising Aramco in Saudi Arabia. The firm is in high-growth stage and is looking at the optimal way to finance it. Looking at petroleum companies in the U.S, it concludes that a significant proportion of capital should come from debt. Is this conclusion justified? Why and why not?

Answer 1

Aramco should not finance significantly from debt. Reasons for this are provided below:

1) As the company is in high growth phase, this may require company to reinvest significantly in its business to fuel its earnings. Therefore if the company uses more mix of equity this will enable it to reinvest its earnings back to its business and avoiding any mandatory charge.

2) As including more debt is quite risky in nature, if the economic downturn comes this will raise cost of financing for Aramco thereby it may face possibility of liquidation because of it being highly levered in adverse circumstances.

3) After becoming mature and stable company, Aramco will be able to have low cost debt considering reliability in its cash flow and more stability to its business. But in growth phase cash flows may be unstable therfore this may lead to high cost of financing.

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