equity & debt

lecture 1

what are shares to a firm

residual claims

→ if a firm goes bankrupt, shareholders are the last to get paid off after all the assets have been sold and loans paid back

how to shareholders receive cashflows

• dividends (timing and magnitude uncertain)

• capital gains (difference between buying & selling price (uncertain))

common stocks also known as

equities / shares

what are tradable US equities

public equities

what is the value of tradeable US equities

$50 trillion

value of global equities in relation to US equities

global equities 2x US

what are stock prices affected by

• economic environment (macroeconomic factors)

• industry factors (oil price for travel industry; changing regulations for finance industry)

• company fundamentals (sales, earnings, etc)

• market psychology (herd behavior, sentiment)

corporate debt source from

corporate bonds

corporate bond is ? distinction with public corporate bond?

• when companies borrow money in public markets by ISSUING bonds

• public corporate debt can be bought and sold by investors, just like equities

how do corporate bond holders receive cash flows?

• coupons (interest payments)

• final principle payment when the bond matures

what’s the key distinction between equities and bonds

corporate bond coupon & principal payments must be paid don time

** if firm misses payment, lenders can sue the company

value of all tradable (public) US corporate bonds is ?

9 trillion

corporate bond prices are affected by

• economic environment (macro factors) esp interest rates!

• concerns about cash flow stability of the firm

what happens when company cannot meet debt payments & goes bankrupt

bond holders get paid BEFORE equity holders

pros of equity financing

• no required cashflows from company to equity holders

• some firms pay annual dividends, but at company’s discretion

• equity holders hope for capital gains via share price increase from strong performance

equity costs

• equity holders expect a higher rate of return (rate of increase of the share price) to offset the risk that the share price might go down

• dissatisfied equity holders will sell their shares

debt benefits

• rate of return for lenders is lower than for equity holders (bc debt is less risky)

• interest payments on debt are tax-deductible (dividends for shareholders are not)

debt costs

• interest and principal must be paid on time: if not, debt-holders can sue

optimal debt/equity mix

• debt is “cheaper” and tax deductible, but company cash flows must be sufficient to cover interest payments

• companies with more stable cashflows can take on a greater proportion of debt

every investment decision balances the tradeoff of

• rate of return

• level of risk