Debt and equity capital each have different risk profiles. Therefore, as we showed in Lesson 103, each type of capital offers investors different return opportunities. Creditors shoulder less risk than shareholders because they are accepting a lower rate of return on the debt capital they supply to a company. When a company pays out the profits generated each year, creditors are paid before anyone else. Creditors can break up a company if it does not have sufficient money to cover its interest payments, and they wield a big stick.
Consequently, companies understand that there is a big difference between borrowing money from creditors and raising money from shareholders. If a firm is unable to pay the interest on a corporate bond or the principal when it comes due, the company is bankrupt. The creditors can then come in and divvy up the firm's assets in order to recover whatever they can from their investments. Any assets left over after the creditors are done belong to shareholders, but often such leftovers do not amount to much, if anything at all.
Shareholders take on more risk than creditors because they only get the profits left over after everyone else gets paid. If nothing is left over, they receive nothing in return. They are the "residual" claimants to a company's profits. However, there is an important trade-off. If a company generates lots of profits, shareholders enjoy the highest returns. The sky is the limit for owners and their profits. Meanwhile, loaners keep receiving the same interest payment year in and year out, regardless of how high the company's profits may reach. By contrast, owners keep whatever profits are left over. And the more that is left over, the higher their return on capital.
Return on Capital and Return on Stock >>