Why do organizations preferred debt capital over equity capital

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Date added: 17-06-26

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The purpose of any research should be very clear and should arrive at an objective. As it is said by McDaniel and Gates (2006), targeted statements that delineate the exact information needed to solve a research problem. Therefore it is necessary to define the objective of research. The objective of this study is to set out the capital requirements in such a proportion that can add value to any organization in either in debt or equity. The proportion should be in a way that should meet the capital requirement and that also can reduce the tax in comparison with dividend to save it. Another aspect of this research is that the structure is also in a way that also not affected the shareholders interest in the organization. In other words the investment opportunities should be there in order to utilise the share value in the financial stock market.

Research Approach

Does an optimum liability and equity structure exist, in other words, a combination of that would allow a maximization of the value of the economic assets for the shareholders? Or, does a totally reliable financial structure such as the WACC is as low as possible?

Traditional Approach

"According to the traditional approach, an optimal financial structure does exist, which will allow the company to maximize its value through the right amount of debts and financial leverage. The company minimizes its HYPERLINK "http://www.ecofine.com/strategy/wacc.htm"WACC, in other words, the cost of financing. The cost of debt is lower than the cost of equity (Kd < Ke) as there is less risk. From that standpoint, any increase in debt will reduce the WACCHYPERLINK "http://www.ecofine.com/strategy/wacc.htm". However, increasing debts creates a higher risk for shareholders. The market will therefore require a higher Ke. The more the company borrows, the higher the rate of interest as the risk increases. The optimal structure is therefore one in which the WACC is minimal. At this rate, the value of the company is maximized."

(ecofine.com 2010)

In order to achieve the above objective, the approach used in the research is should be vital. Study of both quantitative and qualitative aspects will be taken into account. The approach will lead the research into the point of discussion that whether the IBM capital structures in the ideal structure that meet both the requirements if yes than the research is positive if not then what could be the exact structure that can get the desired result. In order to achieve the goals IBM should change their structure that could be possible by issuing new share capital or by increasing the debt finance ratio to get the tax shield and to increase their share value in the stock market.

Literature Review

When a corporation receives money or property in exchange for capital stock (including treasury stock), neither Gain nor loss is recognized by the corporation. Nor does a corporation's gross income include shareholders' contributions of money or property to the capital of the corporation. Moreover, additional money or property received from shareholders through voluntary pro rata transfers also is not income to the corporation. This is the case even though there is no increase in the outstanding shares of stock of the corporation. The contributions represent an additional price paid for the shares held by the shareholders and are treated as additions to the operating capital of the corporation.25 Contributions by non shareholders, such as land contributed to a corporation by a civic group or a governmental group to induce the corporation to locate in a particular community, are also excluded from the gross income of a corporation.26 However, if the property is transferred to a corporation by a non shareholder in exchange for goods or services, then the corporation must recognize income. Significant tax differences exist between debt and equity in the capital structure. The advantages of issuing long-term debt instead of stock are numerous. Interest on debt is deductible by the corporation, while dividend payments are not. Further, loan repayments are not taxable to investors unless there payments exceed basis. A shareholder's receipt of property from a corporation, however, cannot be tax-free as long as the corporation has earnings and profits. Such distributions will be deemed to be taxable dividends to the extent of earnings and profits of the distributing corporation.

E X A M P L E:

Mr XYZ transfers cash of £10,000 to a newly formed corporation for 100% of the stock. In its initial year, the corporation has net income of £4000. The income is credited to the earnings and profits account of the corporation. If the corporation distributes £950 to Mr XYZ, the distribution is a taxable dividend to Mr XYZ with no corresponding deduction to the corporation. Assume, instead, that Mr XYZ transfers to the corporation cash of £5000 for stock and cash of £5000 for a note of the same amount. The note is payable in equal annual instalments of £500 and bears interest at the rate of 9%. At the end of the year, the corporation pays Mr XYZ interest of £450 (£5000 Ã- 9%) and a note repayment of £500. The interest payment is deductible to the corporation and taxable to Mr XYZ. The £500 principal repayment on the note is neither deducted by the corporation nor taxed to Mr XYZ.

Reclassification of Debt as Equity (Thin Capitalization Problem)

Institutions where the corporation is said to be thinly capitalized, the IRS contends that debt is really an equity interest and denies shareholders the tax advantages of debt financing. If the debt instrument has too many features of stock, it may be treated for tax purposes as stock. In that case, the principal and interest payments are considered dividends. The tax advantages of financing a corporation with some debt are clear and beyond question. In fact, debt is so advantageous from a tax perspective that some corporations "overdo it." Nonetheless, some well-known, successful corporations choose to operate without long-term debt. Microsoft, Walgreen, and Cisco Systems apparently have decided that the nontax advantages of avoiding debt (e.g., not having to contend with debt service costs) outweigh the tax advantages of using debt. Such debt-free companies may be the envy of corporations that have relied on debt, perhaps excessively, as a means of financing growth (e.g., US Airways and WorldCom). In some cases, corporate debt does little to enhance a shareholder's investment and may even destroy it.

Methodology

Methodology explains the research plan, it discusses the advantages of data collected and it also forms the base of formatting hypothesis and regression. However, this part of research focuses on the collection method and also explains the right kind of technique and methods used to analyse the data in this study. The most important source of data collection in my research will be secondary but the primary data will also be included. As the research question is "why organizations prefer debt finance rather than equity finance"? So from this the methodology is very simply based on the comparison. The study will be designed in a way that some advantages and disadvantages of both the financing options will be defined in order to drive at a conclusion which would lead the organization in a way that the organization will get all the benefits of tax shield and the dividend reduction but improvement in the share value to give an opportunity and value to their shareholders. There are different ways of research, however i will try to obtain both primary and secondary data, primary data will be obtained by emailing the questioners to the managers and other people related to this field and also a survey in London which would enable me to gather information which could help in understanding the policy and strategies of the organization in the same field, in order to see the whole pictures with a wider range.
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