Question

Students, please view the "Submit a Clickable Rubric Assignment" in the Student Center. Instructors, training on how to grade is within the Instructor Center. Assignment 1: Client Letter Due Week 2 and worth 150 points 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. Use the Internet and Strayer databases 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 and demonstrated in Appendix A of your textbook as a guide. 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. Your assignment must follow these formatting requirements: Be typed, double spaced, using Times New Roman font (size 12), with one-inch margins on all sides; citations and references must follow APA or school-specific format. Check with your professor for any additional instructions. Include a cover page containing the title of the assignment, the student’s name, the professor’s name, the course title, and the date. The cover page and the reference page are not included in the required assignment page length. The specific course learning outcomes associated with this assignment are: Analyze tax issues regarding corporate formations, capital structures, income tax, non-liquidating distributions, or other corporate levies. Use technology and information resources to research issues in organizational tax research and planning. Write clearly and concisely about organizational tax research and planning using proper writing mechanics.

Answer 1

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There are generally two sources of the capital. One is internal and other one is external. The internal capital basically the equity capital and the external capital is the debt capital of the corporation. The formation of the capital is depending upon lots of factors like cost of the capital, financial leverage, tax advantages etc. In the instant situation the formation of the capital is analysis on the basis of the tax advantages. The tax advantages means the tax shield which is generated on the cost of the capital of such resources of the capital. So before conclude the formation on the view of the tax advantages we need to know what is the exact tax advantages generated form these sources of the capital.

In case of the debt capital the tax advantages will be generated on the cost of the debt. Le it discuss with the proper example. Suppose the total debt capital is $100,000 and the cost of the debt is 10% per annum. The tax rate on the profit is 30%. So the total cost of the capital is $10,000 (100,000*10%). But the tax rate is 30%, so the actual cost of debt is $7,000 i.e. tax shield will be deducted from the total cost of the capital. In this example the total tax shield is $10,000*30% = $3,000. So the net cost of the debt is $(10,000-3,000) = $7,000.

In case of equity the tax shield advantages are not there. This is one of the disadvantage of the equity financing. The equity financing are done through issue of equity shares and the stock holders are get dividend from the investment. The tax advantages are not there in case of the debt financing. There are double layer tax on the equity financing.

There is one another factor is there which also plays an important role in the decision making between debt financing and equity financing is “Trading on Equity”. The trading on the equity represent the advantages of the equity financing over the debt financing. Let put it into example. The cost of the debt is 10% and the return of the capital is 12%. So if we borrow $100 from the debt financing then the total cost of capital is $100*10% = $10 and the return of the capital is $100*12% = $12. So the net advantages is $(12-10) = $2. This $2 is the net advantages of the debt financing over the equity financing. This $2 is also used for the internal source of funding of the business. This advantages is occur also for the tax shield on the debt capital i.e. the tax benefit arises on the cost of the debt.

So from the above discussion and analysis it can be conclude that the client should go for the balance financing to maintain the balance of the financial leverage. Prima facie of the fact shows that only the debt financing is the best for the formation of the corporation but if the situation is analysis in details then we can understand there should be balance between debt and equity financing. So it should be kept into the mind and also consider the other factors at the time of forming the capital structure of the corporation. There always should be a balance financial leverage in the capital structure of the capital of the corporation.

References:

Dixit, A. K., & Pindyck, R. S. (1994). Investment under uncertainty. Princeton university press.

Shleifer, A., & Vishny, R. W. (1997). A survey of corporate governance. The journal of finance, 52(2), 737-783.