Corporate Income Taxes - Client Letter - Research Paper Example

Client Letter: Debt vs. Equity Capital Dear Client, I am grateful for this opportunity to give you my expertise advice regarding the pros and cons of debt and equity as forms of capital formation in your new corporation. To make sure there is an understanding I am stating the pertinent problem that needs advice.Problem: advantages and disadvantages of debt vs. equity for capital formation for a new corporation that you own.Facts: debt financing for capital is the raising of money through selling of bills, notes and bonds to investors as well as borrowing money from a financial institution to use for capital expenditure.

In return, the institutions become creditors and the corporation has to promise in writing to pay the stipulated principal and interest (Grinblatt & Titman, 2002). Equity financing on the other is when a company issues shares of the company’s stock and receives money in return. Depending on the capital raised through equity, the company may relinquish about 25% to 75% of the business.Advantages of debt vs. equity capital formationThe advantage of using debt to finance capital expenditure is that you will not give up control of your business.

The lender who is usually a bank or lending institutions does not have any right to manage or oversee how things are run in the business. By simple means, your only obligation will be to repay the loan in regard to the agreed terms. Additionally, interest paid on the loan is tax deductible thus it could be savings in term of tax when the business is still small (Hovakimian, Opler, & Titman, 2001). There is some predictability with debt as the corporation knows exactly how much it owes. The disadvantage for this form of capital formation is that the money has to be paid within a fixed period regardless of the business success.

Relying too much on debt may prove to be strenuous if the business cash flows do not balance. Potential investors may also run away as a huge debt is termed as a high risk. Loans are not just expensive, the lender might also ask for collateral which includes the business assets or personal guarantee which will put you on the hook in case the payment defaults.Equity financing on the other hand does not have to be repaid. The risks and liabilities of the company are shared between the ownership and the investors that come on board.

Since no debt is being repaid, cash flows generated can be used to reinvest back into the company and promote further growth or may be to diversify to other areas of interest. Having a low debt equity ration is advantageous as it puts the company on a better position to acquire loans in future (Klein, O’Brien, & Peters, 2002). Equity investment may sound good but it also means that the corporation has to give up partial ownership and to some extent the decision making authority. Many large equity investors have a habit of placing representatives in executive position so as to oversee the business.

If the business takes off, the profits have to be shared with the equity partners all through its lifetime. This means that distribution of profits over time may exceed the loan that the corporation would have paid.I would therefore advice to take time before deciding. In my opinion a combined equity and debt investment would be great as the risks are distributed; say 70% debt and 30% equity. Thank you for your time and I wish you all the best in the corporation.ReferencesGrinblatt, M., & Titman, S. (2002). Financial markets and corporate strategy.

New York: McGraw-Hill/Irwin.Hovakimian, A., Opler, T., & Titman, S. (2001). The debt-equity choice. Journal of Financial and Quantitative analysis, 36(01), 1-24.Klein, L., O’Brien, J., & Peters, S. R. (2002). Debt vs. equity and asymmetric information: A review. Financial Review, 37(3), 317-349.