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Subject: Operations Management
Variety of Debt Instruments in usiness
As a business makes profits or losses the level of equity in the business will rise or fall. It therefore needs to monitor the effect on the leverage. Profits will reduce leverage and provide the business with capacity to take on further borrowings and vice versa. If a business is making high profits, not growing significantly and using surplus cash to repay debt, its leverage will reduce to a sub-optimal level. This was the case for oil companies between 2005 and 2008 when large profits were generated from the hike in global oil prices. To avoid suboptimal gearing, it may be preferable to distribute excess profits and cash through share buy-backs or special dividends, thus returning money to equity investors and maintaining leverage at a more advantageous level. In recent years many businesses that had established their own company pension schemes with defined employee benefits have found them to be underfunded, in that the net present value of the liabilities to current and future pensioners exceeds the value of investments and contributions. Typically, the reason for this is a combination of increasing life expectancy and lower investment returns than were originally expected. Where a deficit has occurred in a fund there is a potential liability for the business to top up the pension fund should fund performance fail to create the necessary amounts to meet those future liabilities. Investment analysts characterize these deficits as debt when assessing the leverage. Where companies are able to borrow to fund a deficit, it generally makes sense to do so because the interest on the borrowings is tax deductible in the company, whereas the interest earned on the funds deposited in the scheme is tax free. Sometimes a funding instrument can be difficult to classify as debt or equity. An example is convertibles, which typically start by paying a low interest rate. At one or more future dates they can be converted to equity at a predetermined price. The normal rule is to include this type of item as debt up to the point of conversion and equity thereafter. As a business grows it is likely to use a variety of debt instruments and start to create cash flows that have a predictable element (sales revenue) and an unpredictable element (capital purchases