Corporate Finance: Equity vs Debt Fundamentals

Equity and Ownership Interest

Equity represents an ownership interest in a corporation. Key characteristics include:

• Common stockholders vote for the board of directors and other corporate issues.
• Dividends are not considered a cost of doing business and are not tax-deductible.
• Dividends are not a liability of the firm, and stockholders have no legal recourse if dividends are not paid.
• An all-equity firm cannot go bankrupt.

Interest vs. Dividends

Debt is not an ownership interest in the firm. Creditors do not usually have voting power. The corporation’s payment of interest on debt is considered a cost of doing business and is fully tax-deductible. Conversely, dividends are paid out of after-tax dollars. Unpaid debt is a liability of the firm; if it is not paid, the creditors can legally claim the assets of the firm.

Types of Corporate Debt

A debenture is an unsecured corporate debt, whereas a bond is secured by a mortgage on the corporate property. A note usually refers to an unsecured debt with a maturity shorter than that of a debenture, perhaps under 10 years.

Repayment and Amortization

Long-term debt is typically repaid in regular amounts over the life of the debt. The payment of long-term debt by installments is called amortization. This is usually arranged by a sinking fund; each year the corporation places money into a sinking fund, and the money is used to buy back the bonds.

Seniority and Debt Security

Seniority indicates preference in position over other lenders. Some debt is subordinated. In the event of default, holders of subordinated debt must give preference to other specified creditors who are paid first.

Security is a form of attachment to property. It provides that the property can be sold in the event of default to satisfy the debt for which the security is given. A mortgage is used for security in tangible property. Debentures are not secured by a mortgage.

The Bond Indenture

A bond indenture is a contract between the company and the bondholders that includes:

• The basic terms of the bonds
• The total amount of bonds issued
• A description of property used as security, if applicable
• Sinking fund provisions
• Call provisions
• Details of protective covenants