Course 101: What Is the Purpose of a Company?
Different Capital, Different Risk
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

The risks of supplying a company with capital depend on what kind of capital it is. In return for accepting a low rate of return (in the form of interest payments) on the debt capital they supply to a company, creditors shoulder less risk than shareholders. Out of the profits it generates each year, the company pays creditors first. They are first in line. Also, if the company doesn’t have enough money to pay interest, creditors can break up the company and collect the proceeds. They wield a big stick.

From the company’s perspective, then, there's a big difference between borrowing money from creditors and raising money from shareholders. If General Motors can’t pay the interest on a corporate bond, or can’t repay the principal when it comes due, it’s bankrupt. The creditors can then come in and divvy up GM’s assets in order to recover whatever they can. All that is left over after the creditors are done belongs to shareholders. Often, those leftovers don’t amount to much, if anything at all.

Raising money by selling shares is safer for a company. The shareholders only get what is left over, and if nothing is left over, they get nothing. They are the "residual" claimants to the company’s profits. The trade-off, though, is that if the company does really well, shareholders profit the most. Those debt holders just keep receiving their same interest year in and year out, regardless of what profits are. But since whatever is left over belongs to shareholders, the more that is left over, the richer they are.

Next: Returns on Capital versus Returns on the Stock >>


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