Debt Versus Equity for Start Up Essay

  • Length: 2 pages
  • Sources: 2
  • Subject: Finance
  • Type: Essay
  • Paper: #47129834

Excerpt from Essay :

.....debt and equity has a number of different implications, including some significant tax implications. Debt is repaid from earnings prior to taxation, where equity payouts typically occur on an after-tax basis. This is because debt repayments take priority over the payment of dividends or even to stock buybacks or retained earnings. Debt capital is thus repaid before the company is taxed -- debt lowers taxable income. Thus, debt will also lower the total tax burden that the company faces (FindLaw, 2017).

If the company opts for equity financing, it will face a higher tax burden. The taxable income will be higher, which means that the total tax payable will also be higher. Then, the equity that flows to shareholders will do so on an after-tax basis. The shareholders of course will also pay tax on whatever flows they receive. For the corporation, even though it doesn't pay that tax, it is still affected by it, because it means that equity capital has a higher cost of capital than debt. When weighing capital structure decisions, cost of debt is one of the considerations that senior management needs to take into account, because a higher cost of capital essentially demands that the company earn higher returns. This makes sense for a company on a positive growth trajectory, but has its own challenges should the company no longer be growing.

If the company chooses debt, however, it must make the repayments on schedule, and that includes the interest payments. Debt may have a lower cost to it than equity, but it creates more of an immediate burden on the company's cash flow. The upside is the reduction in tax, but if the company was not going to be taxed anyway this would be a strong negative factor. Further, the more debt that the company has, the riskier it becomes because of that cash flow burden, and thus the higher it will pay on subsequent debt (FindLaw, 2017).

2. The company is a young organization, almost assuredly with upside. Without having a sense, however, of how the expected orders will turn to profit, it is difficult to fully advise on the tax implications of capital structure. If the company expects to turn a profit, some debt will help to minimize the cost of capital and the tax burden. That said, any debt that the company…

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