Capital Sources: Equity vs. Debt
Corporations can raise capital through:
- Ownership capital (equity): Funds provided by shareholders.
- Debt capital: Funds provided by lenders, such as bank loans or bonds.
Debt obligations must be fulfilled, and lenders have priority in claim over shareholders in liquidation scenarios. Shareholders, on the other hand, have residual claim to the net assets of the company.
Risk & Return Profiles for Lenders & Shareholders
Shareholders face higher risk due to share price volatility but have the potential for unlimited upside. Lenders, however, have more predictable cash flows and lower risk, but a capped upside based on the interest they receive. As a result, equity investors generally require higher returns than lenders.
Conflicting Interests: Shareholders vs. Lenders
Shareholders may prefer increased leverage for growth potential, while lenders may oppose it due to the increased risk of default. Issuers may prefer issuing debt due to its lower cost but must also consider the impact of increased leverage risk on the company and its stakeholders.
Issuing new shares lowers leverage risk but may dilute existing shareholders’ ownership, potentially creating conflict.
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