The key differences between debt and equity capital

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Unformatted text preview: externally, by selling common or preferred stock. The key differences between debt and equity capital are summarized in Table 7.1 and discussed below. Voice in Management Unlike creditors (lenders), holders of equity capital (common and preferred stockholders) are owners of the firm. Holders of common stock have voting rights that permit them to select the firm’s directors and to vote on special issues. In contrast, debtholders and preferred stockholders may receive voting privileges only when the firm has violated its stated contractual obligations to them. Claims on Income and Assets Holders of equity have claims on both income and assets that are secondary to the claims of creditors. Their claims on income cannot be paid until the claims of all creditors (including both interest and scheduled principal payments) have been satisfied. After satisfying these claims, the firm’s board of directors decides whether to distribute dividends to the owners. The equity holders’ claims on assets also are secondary to the claims of creditors. If the firm fails, its assets are sold, and the proceeds are distributed in this order: employees and customers, the government, creditors, and (finally) equity holders. Because equity holders are the last to receive any distribution of assets, they expect greater returns from dividends and/or increases in stock price. TABLE 7.1 Key Differences Between Debt and Equity Capital Type of capital Characteristic Debt Equity Voice in management a No Claims on income and assets Senior to equity Subordinate to debt Maturity Stated None Tax treatment Interest deduction No deduction aIn Yes the event that the issuer violates its stated contractual obligations to them, debtholders and preferred stockholders may receive a voice in management; otherwise, only common stockholders have voting rights. CHAPTER 7 Stock Valuation 309 As is explained in Chapter 11, the costs of equity financing are generally higher than debt costs. One reason is that the suppliers of equity capital take more risk because of their subordinate claims on income and assets. Despite being more costly, equity capital is necessary for a firm to grow. All corporations must initially be financed with some common stock equity. Maturity Unlike debt, equity capital is a permanent form of financing for the firm. It does not “mature” so repayment is not required. Because equity is liquidated only during bankruptcy proceedings, stockholders must recognize that although a ready market may exist for their shares, the price that can be realized may fluctuate. This fluctuation of the market price of equity makes the overall returns to a firm’s stockholders even more risky. Tax Treatment Interest payments to debtholders are treated as tax-deductible expenses by the issuing firm, whereas dividend payments to a firm’s common and preferred stockholders are not tax-deductible. The tax deductibility of interest lowers the cost of debt financing, further causing it to...
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This document was uploaded on 01/19/2014.

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