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Why do firm’s issue debt?

Firm’s issue debt because they think the return on their future investments will exceed their cost of borrowing. Firms invest across a range of areas, which they feel will be able to create long term, value and boost long-term earning power. Here are some of the primary reasons for issuing debt.

  1. Business Expansion: Entering new markets is generally quite costly and incurs a large amount of fixed costs during the early stages of expansion. Firms may therefore issue debt in order to grow beyond their home markets and improve the long-term prospects of the business. Money spent to enter new markets is generally be recouped as firms are no longer required to outlay large amounts of money to establish themselves in the marketplace. As a business becomes familiar with a new market and grows its sales, economies of scale develop and a solid return can be earned.
  2. To complete a merger/acquisition: A business might decide that acquiring a competitor or firm in a similar industry may allow it to create significant long-term value and boost its earning power, competitive operates and scope of operates. In this case, it would generally choose to issue debt in order to complete the acquisition. It is rare that firm’s would have enough capital to fund an acquisition solely through equity, should the transaction be significant.
  3. To fund capital expenditures/research expenses: Firm’s which operate in industries that have large capital expenditures such as a the oil & gas industry or pharmaceutical industries may often issue debt to fund their capital expenditures during industry downturns, whereby they lack sufficient funding to undertake these operations. In this instance, the usage of debt is absolutely essential; otherwise the business will be unable to undertake its core activities which allow it to generate income.
  4. To repurchase shares: Businesses which feel that their shares are significantly undervalued may decide to issue debt in order to repurchase their shares. Issuing debt has the advantage of being tax deductible, which means that firms are also able to profit from having a lower tax base. This strategy is most commonly used by very mature firms, with very solid business prospects.

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Motley Fool contributor mpinto has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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