Debt Equity Definition
Businesses need money to grow and sustain in the market. They obtain money through two modes--equity and debt capitals. Equity is the money that some individuals plough in the company for ownership therein. In return for the money they have invested, the company issues them stocks. There are mainly two different classes of stocks--common and preferred stocks. Common stocks are bought by venturesome individuals with the understanding that they would gain whenever the company makes profits. Preferred stocks are bought by risk-averse individuals. They are paid a constant rate of dividend whenever the company makes profits.
Debt capital is the loan that some individuals provide the company with. These individuals are called the creditors of the company. They are paid a constant rate of interest periodically, whether the company makes profits or not.
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Significance
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Debt capital is raised with the premise that the investors would be paid interest income at periodic intervals. This happens whether the company has made profits or not. They are usually paid every quarter. In case the company does not make payments to the creditors, they can legally claim its assets.
The equity capital is issued to provide ownership rights to the stockholders. Preferred stockholders get priority in dividend payments and payments in the event of liquidation over common stock holders. Payments to both classes of stockholders are made only if the company makes profits.
Features
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The interest rate on the debt capital and preferred stock are determined at the time the money is obtained. Even when the company makes an enormous volume of profits, both these investors are only paid at the predetermined rate.
After the company discharges, its financial obligations toward creditors and preferred stockholders, whatever remains is the share of the common stockholders.
Credit rating agencies review and rate the volatility and stability factors of both equity and debt instruments.
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Function
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Only the equity shareholders have voting rights in the company. The extent of voting rights are calculated by dividing the number of equity shares an individual possess by the total number of equity shares issued by the company.
There are several options that lie ahead of creditors and preference shareholders to convert their capital into common stock of the company at any time. Usually risk-averse investors do not directly invest in common stock. Once they feel confident that the company is financial stable, they make this move.
Types
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Equity is issued through common or preferred stock, but there are several further types and classifications of these stocks.
Universally issued common shares include: growth shares, blue chip shares, income shares and speculative shares. The rationale governing each of them is different and there are different merits/demerits of owning any one share.
Classifications of preferred stock include: convertible preferred stock, fixed rate preferred stock and participating preferred stock.
Debt capital is bifurcated under two main groups: secured and unsecured loans. Secured loans are those where the company pledges the assets with creditors for the loan. In the event they fail to pay interest income, the creditors can legally claim the assets. Unsecured loans are procured on the basis of the company’s financial standing and goodwill. The creditor cannot legally claim any assets.
Considerations
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There are different types of merits and demerits of investing money in either equity or debt capital. The investor must carefully scrutinize the financial standing of the company, its growth and diversification and his own risk-taking propensity before parking his funds.
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References
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