Partnership is a business organization with two or more owners who agree on sharing profits at an agree ratio but at the cost of unlimited liability. Apart from profits, they must agree on the appropriate management structure also. Following are some pros and cons of a partnership firm:
- It is easy to set up
- It offers diversified decision making process
- Profits fo the firm are taxed only once as onwer’s income
- Regular collisions among partners might be possible and thus achieving consent of all may be slow and expensive
- Since they have unlimited liability, their entire wealth is at risk
- If any partner leaves the organization, this might create capital shortage in the organization
- Cost of Capital and other resources is high for a partnership in comparison to a corporation
A corporation is that form of business organzation that is owned by one or more limited liability stockholders. Generally, in the United States, corporations accounts for just 20% of total business organization but owns 86% of total revenue earned in US market. Following are some pros and cons of Corporations:
- The owners of corproation enjoy limited liability i.e, if the corporation goes bankrupt, its owners are mot required to use their personal wealth to pay off the debts of the entity.
- Since a corporation enjoys economies of scale, they have large scale, low cost capital available.
- A corporation has perpetual life.
- The professional management is not restricted by ability of the owners only as competent workforce is available for a corporation
- Complex management structure can make decisions slow and expensive.
- Retained Profits are taxed twice; i.e both the profits of the company and dividends are taxed by the taxation authorities.
Since Debby, Ella and Jamie are going for a new start up where they are targeting customers in 50+ age range and also with Florida showing high signs of consumers concerned about their health, it is most probable that the above individuals will face a tough competition, and in order to stand out of all the other fitness centres, I will suggest them to incorporate their company. This will offer them all the advantages of a Corporation out of which most importantly will be ability to recruit professional managers that can provide high end health services to the customers. Also, a corporation will help them acquire funds at a low cost in comparison to debt financing from a bank. Thus, if these three individuals continue their bond and do not turn them into complex management, I am sure they will turn out to be successful entrepreneurs.
Also known as Risk Capital, Equity Capital involves private capital of the entrepreneur along with capital raised from family, friends and outside investors like angel investors and venture capital investors.
Advantages of Equity Financing:
Expanded Capital Base:
Equity Financing offers the advantage of raising large amount of capital that are quintessential to fuel the company growth. With Expanded capital base and associated resources with it in the form of Capital Resources, Working Capital Resources, the company can achieve its planned objectives.
Disadvantages of Equity Financing:
Once the company issues their securities in public, they suffer from the disadvantage of diluted ownership. Though investors do not endow any liability on the company for the repayment of their funds, but they gain ownership in the company where they have say in management decisions.
High Cost of Capital:
Since investors assumes the high risk of investment and are not sure of repayment of their invested funds, they demand a high return from the borrower company. Thus, unlike debt, equity is not a cheap source of finance and increase cost of capital of the firm.
Debt Capital is the loan borrowed by the company under an obligation to repay back the funds along with interest.
Advantages of Debt Financing
Low Cost Funding:
Since debt funds are collateralised borrowings, these are available at low cost as compared to equity financing.
As per rules of IFRS and GAAP accounting standards, any interest paid on borrowed debt funds can be claimed as an expense in Income Statement. This lowers the Earnings after Tax(EAT) amount and hence tax liability of the company is decreased.
Disadvantages of Debt Financing
Risk of Bankruptcy:
Lending institutions usually issue debt funds against collateral securities and under the condition of receiving interest and principal payments as per debt covenant. Thus, any default in payments by the borrower entitles the lending institution to claim the hypothecated assets and also to sell and collect unrecovered proceeds from the borrower. This may force bankruptcy and ruined creditability of the borrowing company.
Comparing Debt and Equity Financing:
In the example below, assuming that Earnings before Interest and Taxes of the company are $300000, if Debby, Ella and Jamie opt for Debt Financing, in such case they are eligible to claim interest expense as deductible from their EBIT. However, no such provision is available if they opts for equity financing. Thus, if they opt for Debt Financing, they have lower tax liabilities with them. Hence, Debt is much cheaper source of finaning as compared to equity.
Thus, the company have total common stock issue of 9000 shares and preferred stock issue of 22000 shares.
The question is solved by assuming that Mr.Hansen owns 25%(a quarter) stake in Lifepath Fitness: