Why do firms generally prefer to borrow funds to obtain long-term financing rather than issue shares of stock?

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5 Answers

  • The more firms borrow from debt instead of issuing stocks, the more it can reduce the total cost of capital because the interest from debt is tax-deductible which will help lessen the total cost of capital (the total cost of debt and equity). However, no firm can borrow from debt forever because at one point in time, additional debt financing will cause the total cost of capital to increase instead of decrease. So firms will borrow based on their own optimized capital structure to minimize the total cost of capital as much as possible. And based on this optimized capital structure, there is a limit to how much a firm can continue borrowing from debt.

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  • Because issuing new shares will dilute the ownership of existing shareholders.

    Think of it this way. Let’s say that there are only 2 shares of stock outstanding for Company ABC. You own one share and someone else owns the other share. That means that the two of you own the entire Company. If you and your fellow shareholder decide to issue one more share of stock and sell it to someone else, you would then own only 1/3rd of the company instead of 1/2 of the company. Thus you would only realize 1/3rd of the benefits (dividends, capital gains, etc.) of owning the company instead of 1/2 of the benefits.

  • Issuing additional stock lowers a firm’s EPS

  • Interest on debt is tax deductible. Its the cheapest opportunity cost of capital.

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