Debt for Capital Formation Vs Equity for Capital Formation of a Corporation
Imagine that you are a Certified Public Accountant (CPA) with a new client who needs an opinion on the most advantageous capital structure of a new corporation. Your client formed the corporation in question to provide technology to the medical profession to facilitate compliance with the Health Insurance Portability and Accountability Act (HIPAA). Your client is very excited because of the ability to secure several significant contracts with sufficient capital.
Write a one to two (1-2) page letter in which you:
- Compare the tax advantages of debt versus equity capital formation of the corporation for the client.
- Recommend to the client whether he / she should use debt or equity for capital formation of the new corporation, based on your research. Provide a rationale for the response.
Which is the best way to raise capital for a business? – Sample Answer
Every entrepreneur has to identify the best way to access initial or extra capital for his/her business. The two most common methods of raising such money include taking a loan or equity financing. Deciding between the two methods can be challenging, especially for small business owners who wish to expand their businesses(Cavalluzzo, Wolken& Cavalluzzo, 2000). This paper will explain these two methods so as to help investors decide whether borrowing money is the best option to raise capital or if looking for an investor is a more appropriate option.
Below are some of the major advantages and disadvantages of each method. They include:
This method involves getting an investor who is willing and able to provide the finances required. This method is ideal for any business owner who is unwilling or unable to access debt financing (Vos, Yeh, Carter & Tagg, 2007). Money raised through this method do not come with a fixed repayment plan but it comes with other strings attached such as the requirement that the business owner has to share profits with the investor.
Equity Financing Advantages
Equity is less risky than a loan because it does not have a fixed repayment plan. The investor becomes a shareholder and thus the business owner will not be required to pay the money back(Vos, Yeh, Carter & Tagg, 2007). It is thus accessible to business owners who cannot afford to take on the responsibilities and risk associated with debt.
Unlike in debt financing where the business owner only gets the capital, equity financing comes with added advantage such as free advice from the investor and added credibility. Once a business owner gets into a relationship with the investor, they can easily tap into the investor’s knowledge and network thus gaining more credibility.
Investors focus more on long-term returns and they do not expect to get a return on their investment straightaway(Cavalluzzo, Wolken& Cavalluzzo, 2000). Consequently, the profits earned will not have to be channeled into repayments and thus the business owner can plough back all the money received into the business. If the business fails, the business owner is not liable to repay the money, which is also an added benefit.
Disadvantages of Equity Financing
Using this method of raising capital could be more expensive than employing the debt option. The investor shares in the profits made over a long period of time as compared to debt that interest is paid over the repayment period only (Cavalluzzo, Wolken& Cavalluzzo, 2000). The business owner may end up paying higher returns than the interest rate that they would have paid if they had opted for a loan.
The investor is a business owner and thus they not only have to get a given percentage of the total profits made but they also may require to have control over the decisions made. This could mean that the business owner will need to consult the investor during decision-making processes, which could result in inconveniences(Melicher& Norton, 2011). The business owner may not agree with the investor’s decision but may have to compromise so as to avoid disagreements. In the case of major irreconcilable differencesbetween the business owner and the investor, the business owner may need to buy the investor’s shares or cash in on his/her shares and let the investor own the business fully (Melicher& Norton, 2011). Finally, getting the right investor can consume too much time and recourses, both of which the business owner may not have.
The relationship between the debtor, bank that lends the business owner money, and the business owner is very different from that of a business owner and an investor. The bank does not hold shares in the business it lends money to and thus it does not share in the profits. The bank however requires that the business owner pay a certain amount of money on regular basis, usually monthly, to repay the capital given plus interest charged. If a business takes on too much debt, it may hinder its growth.
Advantages to debt financing
One of the major advantages of using this method to raise capital for a business is that the lender, bank or any other lending institution, does not own any part of the business and thus cannot dictate how the business owner runs his/her business.Unlike in equity where the business relationship is indefinite and the business owner has to keep paying rewards, once the business owner has settled the debt, his/her business relationship with the lender ends. The interest payable on loans is tax deductible, which reduces the business’ tax liability(Vos, Yeh, Carter & Tagg, 2007). Lastly, interest paid on loans can be calculated or easily projected thus reducing uncertainty.
Disadvantages to debt financing
Even with so many advantages, debt financing comes with a number of disadvantages. Loans have to be repaid on regular basis and fixed amounts regardless of the business performance. This means that the business owner may at times be forced to use personal resources to service the loan or even be unable to meet the loan obligation.
Relying heavily on loan could result in cash flow problems for the business, which could in turn affect its on going concern. Additionally, customers, employees, suppliers and potential investors consider a business that is highly in debt as high risk. This could hinder business growth.
When the business owner uses assets as collateral, he/she risks loosing them. In case the business owner is unable to meet the loan obligation, the lender could take away the assets. Such losses could result in further financial strain (Cavalluzzo, Wolken & Cavalluzzo, 2000).
It is advisable that a business owner blends in both equity and debt financing so as to meet the business’ capital needs. The two methods of financing can work well together to reduce the impact of each other’s downsides.
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