Final answer:
Spread occurs when a company earns more income on borrowed money than the interest expense. Firms utilize borrowing methods like banks and bonds to finance growth, with a focus on achieving a higher return on investment than the cost of borrowing.
Step-by-step explanation:
Spread occurs when a company earns more income on borrowed money than the related interest expense. When firms borrow money, they do so with the expectation that the returns on their investment will be greater than the cost of borrowing, which includes interest payments. This expectation of higher returns compared to the interest rate is essential for a firm's growth and financial stability.
Firms have two main methods of borrowing: banks and bonds. Banks lend money at interest, and this borrowing can help both individuals and businesses finance various needs. Bonds are essentially loans made by an investor to a company, with the company promising to pay back the principal with interest.
Return on investment (ROI) is a crucial factor in determining the success of borrowing. The buildup of external debt can be beneficial if the borrowed funds lead to growth and expansion that produce a higher income than the interest expenses. However, if the ROI is less than the interest rate, it can lead to financial difficulties for the company.