Debt vs equity: lenders and shareholders

What do lenders and shareholders each own?

A company pays for its assets with two kinds of money. Debt is borrowed for a finite term, with interest and principal promised on set dates. Equity is the owners’ money, with no maturity and no promise of any payment. Both are paid from the same cash flows, but in a strict order.

Lenders hold a priority claim : they are paid before shareholders, both in operations and if the company is wound up. Suppliers, employees and governments (taxes) are paid before shareholders too. Shareholders hold the residual claim : they receive what is left after every other claim is met, and the board decides how much of that is paid out as dividends.

Claims on the firmfinancing for the assets

• Debt (lenders) Memorize priority, fixed, finite
  • Interest and principal Memorize contractual; interest tax-deductible
  • No vote Memorize protected by covenants
  • Upside capped Memorize paid the promise, nothing more
• Equity (shareholders) Memorize residual, indefinite
  • Dividends Memorize discretionary; not deductible
  • Votes Memorize elect the board
  • Upside unlimited Memorize loss limited to the stake

	Debt	Equity
Claim	fixed, priority	residual
Term	finite	indefinite
Payments	contractual interest and principal	discretionary dividends, set by the board
Tax	interest usually deductible	dividends not deductible
Control	none (protection through contract terms)	votes on the board and major matters
Upside	capped at the promised payments	unlimited
Maximum loss	the investment	the investment
Risk to the investor	lower	higher
Desired outcome	timely repayment	maximum firm value

Which is cheaper for the company, and which is riskier?

For the issuer, debt is cheaper. Investors take less risk, so they accept a lower return, and the interest cuts the tax bill. But debt is riskier for the issuer: the payments are fixed whether profits are high or low, and missing them can end in bankruptcy and liquidation. Lenders may also impose restrictions. Equity costs more, since shareholders demand a higher return for the higher risk, but it carries no promise. From the investor’s side the ranking flips: equity is riskier than debt, because the residual claim moves with every change in profit.

Exam tip Cheaper and riskier for the issuer: debt. Riskier for the investor: equity.

How does leverage change the return on equity?

Using more debt for the same assets is called financial leverage . It shrinks the equity needed, so profit after interest is spread over less equity. The return on equity (ROE) is profit to shareholders divided by their equity. Ignoring taxes:

$$\text{ROE} = \frac{\text{EBIT} - r \times D}{E}$$

Here earnings before interest and taxes (EBIT) is operating profit, $r$ the interest rate, $D$ the debt and $E$ the equity.

The same result can be written as a spread. With no taxes, ROA is operating profit divided by assets, and:

$$\text{ROE} = \text{ROA} + \frac{D}{E}\,(\text{ROA} - r)$$

Each unit of debt per unit of equity multiplies the gap between ROA and the interest rate. A positive gap lifts ROE; a negative gap drags it down.

What is dilution, and why do shareholders prefer debt to new shares?

Dilution is the fall in each existing owner’s fractional ownership when a company issues new shares. Existing shareholders often prefer the company to borrow for growth, unless the new money earns enough to make up for sharing the profits among more owners.

Go deeper Financing one project three ways: new shares, a loan or cash on hand

An all-equity firm has equity of 200 and operating profit of 50, so ROE is 25%. It invests 40 in a project that earns 30% (12 of extra operating profit), so total operating profit becomes 62.

Financing	Net income	Equity	ROE
New shares (40)	62	240	62 ÷ 240 = 25.8%
Loan of 40 at 10% (interest 4)	58	200	58 ÷ 200 = 29.0%
Cash on hand (40, previously idle)	62	200	62 ÷ 200 = 31.0%

New shares give the lowest ROE: the project’s 30% return is only slightly above the old 25%, and the equity grows from 200 to 240. The loan beats shares because its 10% cost is below the project’s 30% return and no new shares are issued. Idle cash is best, because it avoids both the interest and the extra equity.

Go deeper Why a higher corporate tax rate makes debt more attractive

Interest is deducted before tax, so each unit of interest saves tax at the corporate rate $t$. The after-tax cost of debt is $r(1 - t)$. At 6% and a 25% tax rate it is 6% × 0.75 = 4.5%; at 40% it falls to 3.6%. Dividends get no such deduction, so a higher tax rate widens the gap and makes debt relatively more attractive compared with equity.

What do the two claims pay at maturity?

Suppose the debt of $D$ falls due and the firm is worth $V$. Debtholders are paid first. Shareholders get the remainder, but never less than zero, because limited liability stops them from owing the shortfall.

$$\text{Equity} = \max(V - D,\ 0), \qquad \text{Debt} = \min(V,\ D)$$

Both payoffs are asymmetric. Debt is capped at $D$ however high $V$ climbs, and falls only if $V$ drops below $D$. Equity is worth nothing below $D$ and gains one for one above it, with no limit. In both cases the maximum loss is the amount invested.

Why do the two groups want different things?

Shareholders gain all the extra value and lose at most their stake, so they favor riskier projects with higher potential returns, more borrowing and larger payouts. Extra payouts and extra debt make lenders’ claims less safe. Lenders gain nothing from extra upside, so they favor safer projects and steady cash flows.

Conflict of interestsame cash flows, different payoffs

• Shareholders prefer Use it they gain all the upside
  • Riskier projects Use it higher potential returns
  • More borrowing Use it leverage lifts ROE
  • Bigger dividends Use it cash leaves the firm
• Lenders prefer Use it they gain nothing from extra upside
  • Safer projects Use it certain cash flows
  • Low leverage Use it room to be repaid
  • Covenants Use it coverage and leverage limits

Because lenders have no vote, they protect themselves in the contract. Covenants are restrictions written into the debt agreement, such as a minimum cash-flow coverage of the interest or a limit on leverage. They stop actions that help shareholders but reduce the chance of repayment.

Go deeper Why equity is more sensitive to firm value than debt

If firm value rises, the gain goes to shareholders and lenders’ payments do not change. If it falls, the loss lands on equity first. Only when $V$ drops below $D$ does debt start to lose value too, and by then equity is already zero. That is why share prices move more than bond prices when a company’s fortunes change.