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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
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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