Question

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 enough capital.

Use the Internet and Strayer Library to research the advantages and disadvantages of debt for capital formation versus equity for capital formation of a corporation. Prepare a formal letter to the client using the six (6) step tax research process in Chapter 1 that was demonstrated in Appendix A on page 7 of your textbook as a guide.

Write a one to two (1-2) page letter in which you:

1. Compare the tax advantages of debt versus equity capital formation of the corporation for
   the client.
2. 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.

Answer 1

To

The Management

Issue: Appropriate capital structure mix

Aspects to be considered:

Capital structure is significant for a firm because the long-term profitability and solvency of the firm is sustained by an optimal capital structure consisting of an appropriate mix of debt and equity.

The capital structure also is significant for the overall ranking of the firm in the industry group. The significance of the capital structure is discussed below:

1. It reflects the firm’s strategy - The capital structure reflects the overall strategy of the firm.

2. It is an indicator of the risk profile of the firm - If the debt component in the capital structure is predominant, the fixed interest cost of the firm increases thereby increasing its risk. If the firm has no long-term debt in its capital structure, it means that either it is risk averse or it has cost of equity capital or cost of retained earnings less than the cost of debt.

3. It acts as a tax management tool - Since the interest on borrowings is tax deductible, a firm having healthy growth in operating profits would find it worthwhile to incorporate debt in the capital structure in a greater measure.

The important decision of the management is to determine the correct mix of debt and equity in the capital structure.

Advantages of debt include:

1. Tax deductible: Interest on debt is tax deductible. Companies with high operating earnings can include more debt to get the benefit of tax.
2. Less cost of capital: As debt holders get a fixed amount of interest and fixed amount of repayment on maturity, the cost of debt is lower than that of equity.
3. No dilution of control: Issue of debt will not dilute the control of the company.

Disadvantages include:

1. Fixed obligation: Interest should be paid irrespective of whether the company is earning profits or making losses. In case of losses, it would be a burden to the company to pay interest.
2. Debt covenants: Some restricting debt covenants restrict company from obtaining further capital or debt, causing hindrance to growth.

Advantages of equity include:

1. No obligations to pay dividend or repayment of capital: The company has no obligation to pay dividends. The capital of equity holders is repaid only after all other obligations are met. Hence, the liabilities are not fixed.
2. No restricting covenants: The company has no restrictions on issue of equity capital.
3. Control of the company: Equity holders have voting rights through which they exercise their controlling power.

Disadvantages include:

1. No tax advantage: Payments made to equity holders are not tax deductible. Moreover, dividend distribution tax should be paid by the company.
2. High cost of capital: Because the returns are highly uncertain to equity holders, they demand high returns, resulting in higher costs of capital.

Conclusion: Considering the nature of business, objective, estimated earnings, nature of earnings, the management should decide about the mix of equity and debt, considering the advantages and disadvantages of both.

Thank you