The use of debt financing
A) causes a manager to take on riskier projects in order to make interest payments.
B) is more expensive than issuing equity due to the use of covenants.
C) allows managers to make discretionary interest payments.
D) limits the ability of managers to waste stockholders' money.

Question

Quizplus · Accepted Answer

Debt financing typically comes with covenants and repayment obligations that limit the ability of managers to waste stockholders' money. This is because the lenders have the ability to hold the company accountable for meeting certain financial and operational metrics, and failure to do so can trigger default and potentially bankruptcy. Therefore, managers are incentivized to use debt financing prudently and allocate capital to more financially viable projects. Option A is incorrect because managers may choose to take on riskier projects regardless of the financing source, and debt financing does not necessarily increase this inclination. Option B is incorrect because the cost of issuing equity may be higher than the cost of debt financing, depending on the company's credit rating, cost of capital, and other factors. Option C is incorrect because discretionary interest payments would undermine the creditor's ability to enforce the terms of the loan and protect their investment, which would make debt financing less attractive to lenders.

The Use of Debt Financing