BBC (2009) stated that De Beers plans to
raise its capital investments from investors to $1billion to reduce its debts.
I think about my previous lecture topic’s capital structure. If the low level
WACC of project presents high level of present value of future cash flows thus
shareholders’ wealth is increasing, it will be beneficial to company with high
level of debt. As the debt level increases, the actual cost of loan to the
company is lower because the interest on the debt is deduced. Moreover, lenders
does not share profits to company’s profit. They only require a fixed amount of
interest annually. In addition, lenders do not dilute ownership interests and
control of existing shareholders. In general, the cost of debt financing is
cheaper than equity financing.
However, why De Beers plans to increase
equity instead of debt? The problem incurs because of advantage of debt
compared to equity which is company only has to pay a fixed amount of money and
doesn’t have to pay any extra amount of money when company makes profit.
Problem is what about when company makes lose? Company still has to pay that
amount of money without any discount. De Beers experiences a bad year in which
first-half profits fall by 99% as a result of a collapse in the price of
diamonds. How can De Beer pay for the interest of current amount of debt
($3.5bn) while it has financial trouble? In this case, I think the De Beers’ s
decision to increase level of equity is right. According to the case, it remind
me about the advantages of equity compared to debt, during difficult financial
periods, high level of equity can avoid company from risk because equity
financing does not require to be paid. Moreover, the larger level of gearing,
the more risky lenders and shareholders consider company. Lenders and
shareholders would require more interest and dividends to guarantee their
interests.
Source:
http://news.bbc.co.uk/1/hi/business/8387839.stm
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