Borrowed Capital

Understanding Borrowed Capital

Borrowed capital is a term commonly used in the realm of corporate finance, referring to the funds that a company utilizes which are obtained through debt instruments. These include loans, bonds, or other forms of debt rather than equity. Borrowed capital is essential for the strategic growth and daily operations of many businesses, allowing them to leverage additional financial resources.

Key Characteristics

Fixed Cost: Interest payments are a fixed cost and must be serviced regardless of the company’s financial performance.
Ownership: Borrowed capital does not dilute ownership, unlike equity financing where investors gain a share of control.
Leverage: By using borrowed capital, companies can leverage their investments, potentially increasing their return on equity.

Examples of Borrowed Capital

Bank Loans: A traditional way for businesses to obtain borrowed capital. For instance, a business may take out a loan to purchase new machinery or expand operations.
Bonds: Corporations may issue bonds to raise capital. Investors purchase these bonds, effectively lending money to the company in exchange for periodic interest payments and eventual repayment of the principal.
Commercial Paper: Short-term unsecured debt instruments issued by a company to finance its short-term liabilities.

Frequently Asked Questions

Q1: What is the difference between borrowed capital and equity capital? A: Borrowed capital involves funds obtained through debt that must be repaid with interest, while equity capital involves funds raised from investors in exchange for ownership stakes in the company.

Q2: What are the risks associated with borrowed capital? A: The primary risk is the obligation to make fixed interest payments regardless of financial performance, which can strain cash flow. Excessive borrowing can also lead to financial distress or bankruptcy.

Q3: How can borrowed capital affect a company’s financial leverage? A: Borrowed capital increases a company’s financial leverage. While this can amplify returns on equity in profitable periods, it also increases financial risk during downturns.

Q4: Can borrowed capital be used for any purpose? A: Borrowed capital can generally be used for various purposes, including expansion, asset acquisition, and operational expenses. However, the specific terms of the borrowing agreement may impose certain restrictions.

Q5: How is interest on borrowed capital treated for tax purposes? A: Interest payments on borrowed capital are typically tax-deductible, which can reduce the overall taxable income of a business.

Bridging Loan: A short-term loan used until permanent financing can be secured or an obligation is removed.
Debt Financing: Raising capital through the sale of bonds, loans, or other forms of debt.
Leverage: The use of various financial instruments or borrowed capital to increase the potential return of an investment.
Principal: The face amount of a loan or bond, exclusive of interest.

Online References

Suggested Books for Further Studies

“The Essentials of Finance and Accounting for Nonfinancial Managers” by Edward Fields
“Principles of Corporate Finance” by Richard A. Brealey and Stewart C. Myers
“Financial Management: Theory & Practice” by Eugene F. Brigham and Michael C. Ehrhardt

Accounting Basics: Borrowed Capital Fundamentals Quiz

### Which of the following is NOT a form of borrowed capital? - [ ] Bank Loans - [ ] Bonds - [ ] Commercial Paper - [x] Issued Shares > **Explanation:** Issued shares represent equity financing, not borrowed capital. Bank loans, bonds, and commercial papers are all forms of borrowed capital. ### What is the primary benefit of borrowed capital over equity financing? - [x] It does not dilute ownership - [ ] It does not need to be repaid - [ ] It has no cost - [ ] It provides voting rights > **Explanation:** Borrowed capital does not dilute ownership of the business, as lenders do not gain control or voting rights over company decisions. ### What must be paid on borrowed capital regardless of the company's financial performance? - [ ] Dividends - [ ] Principal only - [x] Interest Payments - [ ] None of the above > **Explanation:** Interest payments on borrowed capital must be made regardless of the company's financial performance, as they are a fixed cost. ### What type of financial instrument is issued as a short-term unsecured debt by a company? - [ ] Bonds - [ ] Equity Shares - [x] Commercial Paper - [ ] Mortgages > **Explanation:** Commercial paper refers to short-term unsecured debt instruments issued by companies to finance their short-term liabilities. ### Which of the following statements about leverage is true? - [ ] Leverage decreases financial risk - [ ] Leverage has no impact on return on equity - [x] Leverage increases potential return on equity, but also financial risk - [ ] Leverage is achieved through issuing equity > **Explanation:** Leverage increases potential return on equity as well as financial risk because it involves using borrowed funds to amplify financial outcomes. ### What happens to the company’s cash flow when using borrowed capital during downturns? - [x] It strains the cash flow due to mandatory interest payments - [ ] It improves cash flow since no interest is due - [ ] It has no impact on cash flow - [ ] It generates additional revenue automatically > **Explanation:** Borrowed capital can strain a company's cash flow during downturns due to the need to service fixed interest payments despite lower revenues. ### In what scenario can borrowed capital lead to financial distress? - [x] When the firm is unable to meet its periodic debt obligations - [ ] When the firm’s revenues exceed its expenses - [ ] When the firm expands its operations - [ ] When the firm decides to issue new equity > **Explanation:** Borrowed capital can lead to financial distress if a firm is unable to meet its periodic debt obligations, leading to potential defaults or bankruptcy. ### True or False: Borrowed capital typically comes with voting rights. - [ ] True - [x] False > **Explanation:** Borrowed capital does not come with voting rights. Lenders and bondholders have no control over company decisions unlike equity shareholders. ### Which term describes the face amount of a loan exclusive of interest? - [ ] Leverage - [ ] Collateral - [ ] Amortization - [x] Principal > **Explanation:** The principal represents the face amount of a loan or bond, exclusive of interest. ### What tax benefit is associated with borrowed capital? - [ ] Exemption from income tax - [ ] Tax-free status of interest earned - [x] Tax deductibility of interest payments - [ ] No benefits > **Explanation:** Interest payments on borrowed capital are typically tax-deductible, reducing the overall taxable income of a business.

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