External Financing debt vs.
equity
Debt
Debt may be in the form of short-term debt or long-term debt.
- short-term debt
- long-term debt
Cost of debt — interest payment, which is deductible from gross income, resulting in the recognition of
tax benefits.
Equity
Equity financing may be in the form of contribution in cash or in property by partners in a partnership or
issuance of capital stock by a corporation.
- Common stock
- Preferred stock
Cost of equity — dividend payment, which is NOT deductible from gross income, hence, no tax benefit
can be derived
Strategy
Managers search for an optimal capital structure in the long run.
- not-for-profit organization
- for-profit organization
Value-adding
A key aspect of debt financing is leverage. Debt adds value when debt increases operating cash flows in
excess of the required periodic payments of interest and repayments of principal.
For example, ABC Company and XYZ Company have the following financial information:
If we assume that these companies operate in the Philippines and are subject to corporate income tax
rate of 30%, and the debt and equity investors demand a 10% pretax return, the cost of capital would be:
The higher the relative use of debt, the greater the risk of bankruptcy or costly debt renegotiations.
From the point of view of providers of fund, investing in equity is riskier than investing in debt.
Investing in equity is riskier, yet, there are possible tax offsets to reduce risk. Share price appreciation is
not taxable until the investments are sold. In case the stocks investments were sold directly to another
investors, any gain or loss on such a sale is considered capital gain or loss. If the sale results in a capital
loss, such a loss shall be deductible only to the extent of capital gains from the same type of transaction
during the same period. The resulting net capital gains shall be subject to 15 percent capital gains tax.
Moreover, in case of liquidation, only 50% of the capital gain is subject to basic income tax subject to
holding period of more than 12 months. But if the shares are sold through local tax exchange, a stock
transaction tax of 0.6% on the gross selling price shall be imposed, not income tax. Even if the sale
results in a loss, such a loss is not deductible for tax purposes.
For example, On January 1, 2021, Mr. A invested in P1 million for common stock in a start-up company.
The information on the company’s earnings and appreciation of the investment is shown below.
Net Income of the Value of the Mr. A’s
End of Year
Company Investment
2021 P500,000 P1,500,000
2022 P1,000,000 P2,000,000
2023 P1,500,000 P3,500,000
If at the end of 2023, Mr. A sold his investment to Mr. B for P5,000,000, Mr. A will pay P600,000 capital
gains tax.
In case the company was liquidated at the end of 2023 and Mr. A received P5,000,000, the tax
implication would be
The net capital gain will form part of Mr. A’s gross income. If this is the only income of Mr. A, the income
tax payable using the graduated tax rates would be:
Non-Deductible Interest Expense
1. Interest paid in advance
2. Interest on amortization
3. Interest payments made between related taxpayers
4. Interest on indebtedness incurred to finance petroleum exploration
5. Interest treated as capital expenditures
