Question

Why might a firm take on more debt than it can afford?

Answer 1

Sometime a firm might take issue debt more than it can afford. The firm can might take such decision if the cost of debt is less than the return generated by utilizing the proceed amount to generate more sales.

E.g. Say, The company raised debt amount of $100. The Cost of debt is 10%. If the firm is able generate sales of $120 with cost of cost of $100. So, here the net profit = 120-100-100*10%=$10

So, here company is paying interest of $10 as interest on $100 debt but utilizing this money company is generating a net profit of $20 which is more than the interest paid. In this type of scenario company will be able to issue debt more than it can afford.

This strategy involves risk as the firm has to be very sure about it's business model and full utilization of the net proceed amount of debt.