Friday, January 30, 2015

Equity and Debts

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Investment in Corporate Sector
Suppose, you want to invest in a corporate sector. What options do you have?

You have two options for investment - invest in stocks/equity/share or invest in bonds/debentures of the company.

First option points to Equity instrument, whereas the second option to Debt instrument.

Equity Instrument
If you buy an equity instrument (i.e., shares), then you will be a (kind of) owner of the company, known as stakeholder or shareholder. The company is not liable to you. If the company generates profit, then you will get a part of it (as dividends, will explain later), and if generates loss, then you too have to bear it.

You buy a share by paying an amount to the company, you don't get anything in return except the claim of being a stakeholder or shareholder. You will be only profited (i.e, benefited), when the company provides dividends to its shareholders.


Debt Instrument
If you buy a debt instrument (i.e., bonds, debentures), then you will be a liability of the company, and you won't be the (kind of) owner of it. Whether the company generates profits or make loss in its business, it is bound to provide you the investment you made as bonds or debentures, with interest.

You buy a bond, you will get monthly/quarterly (whatever the payment time is) return from the company, where you invested. But you will never be a stakeholder.


Now, try to summarize the differences of equity and debt instruments -


Equity
Debt
Nature
Equity, or Stock are securities that are a claim on the earnings and assets of a corporation.
Debt instruments are assets that require a fixed payments to the holder, usually with interest.
Use
Allows a company to acquire funds, often for investment, without incurring debts
Issuing a bond (debt instrument) increases the debt burden of the bond issuer because contractual interest payments must be paid – unlike dividends, they cannot be reduced or suspended
Ownership
Those who purchases equity instruments (e.g., stocks) gain ownership of the business, whose shares they hold. In other words, they gain the right to vote on the issues important to the firm. In addition, they have claims on the future earnings.
Bond holders do not gain ownership in the business or have any claims to the future profits of the borrower. The borrower’s only obligation is to repay the loan with interest
Risks
Share holders gets profits or losses, as and when business makes it, making it highly risky
Bonds are less risky – should the company run into trouble, bond holders are paid first, before other expenses are paid.
Earnings
Investors only earns when company issues dividends, that happens when the company wants to share the profit to their share holders
Returns are periodic and almost fixed. Coupons or monthly interest is earned.
Raising Capital
Raising capital using equity is that the company who issues shares need not pay any money to the share holders.
Raising capital using debt is a burden to the company, as they have to pay the interest monthly
Instruments
Shares, Dividends
Bonds, Debentures, Certificates, Mortgages, Leases, Notes, or other agreements between a lender and a borrower




Dividends and Debentures
Now come to dividends and debentures. Don't get confused on these two. Dividends is a equity instrument, whereas debenture is a debt instrument.

Dividends - When a company generates profits, it can use that amount whether as reinvestment in the company (to extend business, or buy new equipment, etc.), or as to share among the stakeholders / shareholders, or both.
If it shares the profit among the shareholders, then it is known as Dividends (generally denoted as Dividends Per Share, or DPS). Shareholders gets dividends on per share basis.

Debentures - It is a kind of debt instrument, but without collateral. You will buy a debenture only because you believe that the issuer (may be a company or government) will not default on its payment to you. They will not provide any security as collateral for your investment. The reputation of the issuer is enough for you to buy a debenture.

The best example could be a Treasury Bill (T-Bill), issued by government. You know that government will never default on payment, so you buy a T-Bill, which is a debenture. (I shall elaborate T-Bill in next blogs)



Hope I have cleared your doubts about these complex concepts. You are welcome to ask for more help about these in comments section below.


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Happy learning!

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