Course 101: What Is the Purpose of a Company?
The Two Types of Capital
In this course
1 Introduction
2 Money In, Money Out
3 The Two Types of Capital
4 Different Capital, Different Risk
5 Returns on Capital versus Returns on the Stock
6 Ownership Interests

Back to our spouts. Two types of investors shovel their money into companies: creditors and shareholders. Creditors provide a company with debt capital, and shareholders provide it with equity capital. Creditors could be banks, bondholders, or suppliers. They lend money to the company, and in return they hope to get a fixed return on their money (in the form of interest payments). That interest rate will be higher than the return on (or interest rate of) government bonds—companies are riskier than the government—and it will be commensurate with the risk associated with the company. A steady company can borrow money cheaply, whereas a risky, unpredictable business will have to pay more.

Shareholders, by contrast, don’t get a fixed return. When a company sells shares to the public, it’s actually selling an ownership stake in itself, not a promise to pay a fixed amount each year. Instead of just a few insiders owning the bulk of the company, the insiders bring in the public as part owners; hence the phrase "going public." This practice raises money. As part owners, shareholders are not entitled to a fixed return on their shares. Like the original owners, they are entitled to the profits—if any—that are left over after everyone else (employees, top executives, creditors) gets their money.

Those profits may be paid out as dividends, in which case shareholders get cold cash. Usually, though, only some of the earnings are paid out as dividends; management invests the rest back into the company on behalf of shareholders.

Many companies, especially young ones, pay no dividends. Any profits they make are plowed back into the company. One of the most important jobs of any company’s management is to decide whether to pay out profit as dividends or to reinvest the money back into the company. Companies that care about their shareholders will only reinvest the money if they have promising projects to invest in—projects that should earn a higher return than the shareholders could get on their own.

Next: Different Capital, Different Risk >>


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