Question

Questions:

1. What are the advantages of debt over equity? If debt is cheaper, why would anyone choose equity? How do taxes play a role in this?
2. Assume the following for a standard bond issue within the United States:
   1. The face value of the bonds is $95,000.
   2. Stated rate on the bond is 8%.
   3. Interest is paid every 6 months (8%/2 = 4% every payment).
   4. The bonds are due in 10 years.
   5. Assume 3 scenarios, the market rate is 8%, 7%, and 10%.

Provide an amortization table for all 3 scenarios as well as the journal entries for the inception of the issue and the first interest payment. Use Excel for the question, it will greatly decrease the time you need to spend on it.

Answer 1

A debt is money borrowed by one party from another party with a promise to pay it back on a fixed later date usually with an interest amount.

Equity is the value of money which is owed to the shareholders at the time of liquidation of the business.

Benefits of debt over equity is as follows:

Issuing of equity leads to the dilution of ownership of the company, while on the other hand a relationship with a debtor is over when the debt is repaid, and no ownership has to be transferred to the debtors nor do they have a say in how the owners run the business.

Another advantage is that the interest paid for a debt is a tax deductible expenses while the dividends that need to be paid to the shareholders are not.

Debtor has the right only to the principle and the interest amount payable for the debt and cannot claim the rights for the profits of the business.

Another advantage include that the principal and the interest amount of a debt is a known amount and can be forecasted and planned for.

Raising capital through debt is considered a less complicated process than raising capital through equity as it has less regulations and rules.

Why choose equity over debt?

Equity shareholders are also known as the owners of the company.  

Even though debt is a cheaper option people would prefer equity because equity shareholders has a right to the profits of the organization, so while the organisation make huge profits the equity shareholders can claim it while the debtors cant. They also have the right to vote and participate in deciding the affairs of the organisation.

Tax Rules

Tax on interest for debt is a tax deductible expense while the dividend paid to shareholders are not tax deductible.