CLIENT LETTER 5
Iappreciate the chance to advise you relating the merits and demeritsof debt vs. equity for capital formation for you newly createdcorporation. I understand that you provide technology to the medicalprofession to facilitate their operations in the medical field. Thisletter is designed to introduce you to some of the considerationsbearing on the type of capital formation structure that is best foryou corporation. Debt financing is when a corporation raises fundsfor working capital by selling, notes, bills and bonds to otherindividual and entity investors (Friedman, 2007). Such individual orentity effectively become firm creditors and receive a promise thattheir money and interest of debt shall be repaid as stipulated in theterms of credit. On the other equity, financig is a type of capitalformation in which the corporation issues shares of its stock andgets funds in return (Friedman, 2007). Based on how the corporationraises equity capital, a firm must relinquish a given percentage ofthe business.
Acommon way of raising capital with debt for a corporation is to takea loan from a financial bank. In this form of borrowing, no taximplications exist for accessing and refunding the loan, even thoughthe interest that such debt attracts are deductible as an ordinarybusiness expense. The deduction’s only condition is that thecorporation is legally accountable for covering that expense and thatthe principal funds are used for company operations (Block, 2004).
IssuingBonds and Deducting Interest
Thisis a more sophisticated process of capital formation mainly used bythe large corporation. The corporation issues bonds to investors.Bonds signify credit provided by numerous investors, rather than afinancial institution (Friedman, 2007). Individuals and firms whoinvest in bonds earn money through payments of interest that thebusiness makes after a fixed period or as a lump sum after the lapseof the bond period (maturity). Maturity date signifies the day whenthe principal amount ought to be repaid (Block, 2004). Under certainarrangement, investors get imputed interest, which results wheninvestors give the firm less money than they shall get back afterbond maturity. It s important t note this difference is taxed forinvestors and deducted by the firm as interest. A substantialbenefit to the firm is that they take yearly deductions for a portionof the imputed interest although no payment is actually made till thebond matures. This is always the scenario with zero-coupon bonds(Hoffman, 2015).
Thecorporation may opt to sell equity in the firm to raise funds byissuing share of stock. Such a transaction doe does not attract anytaxation to your corporation or the new stockholder. Nonetheless, infuture the new stockholders may expect taxable dividend payments inthe financial years where a firm makes profit. Such dividends are notdeductible by the corporation (Block, 2004).
Asyou can observe there are certain advantage of each method of capitalformation depending on the current and future net cash inflows andoutflows. The movement of cash may make one debt financing preferablemethods at certain times and equity financing at other times. Forexample, if you do not expect the additional capital to increasesprofit margins on the coming years, equity financing is a preferablemethod. Under such a case, the corporation will not be required torepay any fund to the shareholders, dividends and other distributionare not made, and interest does not accrue (Hoffman, 2015).Nonetheless, equity financing does not have any implications on tax(for the corporation).In respect to taxation, debt financing is abetter method of financing because interest on the debt is deductedfrom the operating income before income taxation. This means thatdebt financing has a tax advantage because it reduces the taxableamount in the income statement since interest payments on debt aredeductible, but dividend payments on capital formation are not(Hoffman, 2015). Dividend reduces retained earnings that only affectshareholders equity.
Yourcorporation should use debt financing because interest on loan shallbe deducted before taxation, meaning the income generated payscreditors before it is taxed, which significantly reduces amount paidin form of taxes.
Block,C. D. (2004). Corporatetaxation: Examples and explanations.New York, NY: Aspen Publishers.
Friedman,B. M. (2007). TheChanging roles of debt and equity in financing U.S. capitalformation.Chicago: University of Chicago Press
Hoffman,W., Raabe, W., Maloney, D and Young, J. (2015). South-WesternFederal Taxation 2016: Corporations, Partnerships, Estates andTrusts.Boston, MA: Cengage Learning