| 
  • If you are citizen of an European Union member nation, you may not use this service unless you are at least 16 years old.

  • You already know Dokkio is an AI-powered assistant to organize & manage your digital files & messages. Very soon, Dokkio will support Outlook as well as One Drive. Check it out today!

View
 

equity

Page history last edited by Brian D Butler 15 years, 1 month ago

Equity

 

Equity on the balance sheet is what the stockholders would have left over after the company paid all of its obligations.  It is one concept of finance. The accounting value of shareholders equity increases when the firm has retained earnings (which result when the income statement shows a profit, and not all profits are distributed in dividends).

 

Think "stocks" = equity  (while bonds = debt)

 

The main difference between equity and debt is that equity is what is left over after the company first pays their debts.   So, if the company borrows money from a bank (debt) and also has some money from the owners (equity), then each month the company must first pay back the interest on the loans (and plan on paying back the principal of the loans) before the company can give any money back to the equity holders in a form of "dividends". 

 

Equity is more expensive to the firm than is debt financing.

 

While debt is a promise to pay a fixed amount by a certain date....equity carries no such promises.   If you don't make money in the future, you never have to pay back the equity investors!  But, you do have to contractually pay back the debt holders (banks, bondholders, etc).  For this reason, the equity holders are carrying much more risk.  If you only make some money, but not enough to pay both equity and debt holders...then you will pay the debt holders first, and whatever is left over can go to the equity holders.

 

Because equity holders have more risk, they should also demand a higher return.  When you look at the overall cost of capital for the firm (WACC), it is clear that equity financing is much more expensive, and explains why companies often prefer debt financing in their capital structure decisions. 

 

If equity is riskier, then why do stockholders invest in a firm?

 

Because their potential upside returns are much higher.  By investing in the equity of a firm, you are becoming a part-owner of the firm.  If they do well, you will do well. 

 

While debt holders have a guaranteed minimum amount that they will be paid, that is also the maximum that they will be paid.  They do not get to share in the growth potential if the firm is wildly successful.   Debt holders are paid their interest and principal, but then all other profits go to the owners (equity holders of the firm). 

 

In financial terms, the equity holders have "contingent claims" on the total value of the firm.  I.e they get the residual value of the firm after the bondholders are paid.   If the value of the firm is less than what is owed to the debt holders, then the equity holders get nothing, and the entire value of the firm goes to the bond holders.

 

 

 

Thinking in terms of Options

 

 

The stock of a company can be thought of as a "call option" on the firm.  The value of the call option increases with volatility, and a rise in volatility will increase the value of the stock of the firm.  This means that the value of the stock equity will increase as the firm selects riskier projects.  But, on the other hand, the value of the bond holders will decrease as riskier projects are selected.  This can also be seen in terms of Options.   The value of a risky bond can be seen as the difference between the value of the firm and the value of the call option on the firm.  So, as the value of the call option increases (value of the stock increases), this means that the value of the bonds decreases.  The bondholders are therefore hurt when the firm selects riskier projects. 

 

 

Common vs Preferred:

 

Example...CitiBank Nationalization in Feb 2009: 

 

Treasury will convert up to $25 billion of preferred shares, matching dollars that Citigroup is able to bring in from other investors, such as sovereign wealth funds.    It will virtually force those other preferred share investors to convert to common shares by eliminating most preferred dividends as well, although the government will continue to get an 8% dividend on the $20 billion in preferred shares it is not converting….Friday's move could very well be the first of similar actions taken by the federal government going forward. The Treasury Department said in its rescue plan, unveiled this week, that any major bank that comes up short in the so-called "stress tests" now being conducted will be required to raise more capital, and that may be accomplished by converting the preferred shares that Treasury now holds in each of the institutions. Source: CNN

 

As the Economist said back in January:

 

Preferred stock …is not a substitute for common equity. It makes shareholders more geared, raising share-price volatility. And it does not boost the long-term capacity of a bank to absorb losses without defaulting. As a result it does not increase such banks’ appetite to lend.

 

Continued:

 

Under the original 1988 Basel 1 rules governing bank capital, the bulk of banks’ tier-one capital had to be common equity. This can suffer losses without defaulting, need not receive a dividend and does not have to be repaid. But banks were also allowed to include some preferred stock, which sits somewhere between debt and equity. Such hybrid capital suffers losses only once the common equity has been wiped out and typically offers more secure dividends.

 

 

Links:

stock market

equity (stock)

issuing shares

Board of Directors

stock options

dividends

stock splits

treasury stock

 

Comments (0)

You don't have permission to comment on this page.