Bonds and equities are the most common financial assets, with distinct features that might appeal to different investors with different priorities and preferences. The characteristics of these assets, affecting the capital structure and the cost of capital, are also critical for the issuers. Here are the differences between these assets that the investors/issuers need to know to decide the best way to invest and raise funds.
To partner or not to partner:
The stock of a company represents ownership in that company. Being a partner provides some privileges. First, as a partner, you have the right to vote on significant issues affecting the company. The most crucial point would be the election of the board of directors. Since they elect the board of directors, they have a voice in the company's management and indirectly influence even the fundamental daily operational issues on which they can't vote.
On the other hand, debt is not an ownership interest in the company. This might lead to a conflict of interest for the debt holders. The managers might act in favor of stockholders and against the interest of debt holders. For instance, a company's management about to default might distribute dividends or invest in risky projects even with a negative value. Bondholders use protective covenants, such as limitations on additional debt or restrictions on new capital investments, to limit the actions of the management that would damage their interests.
Tax shield vs. default risk:
The interest on debt is a tax-deductible cost and provides a tax shield. More interest expense lowers the tax paid by the firm and consequently decreases the cost of capital. On the other hand, dividends paid to shareholders are not tax-deductible. Therefore, the company management would prefer debt to equity. Current shareholders would also prefer to use debt rather than to issue new stocks since the new stock issue would cause diluted ownership for the current stockholders. Although the current shareholders might have the right to buy the newly issued shares before offering them to the public, they might have enough funds to exercise this option. However, excessive debt might weaken the company's financial strength and lead to bankruptcy.
Debt is a liability of the firm. The borrower is expected to make scheduled interest payments and the principal payment at the loan's maturity. If the company misses these payments, the creditors have the right to demand the company's liquidation. More debt would make it harder to meet these obligations and increase the possibility of financial failure. The economic literature recommends an optimum level of debt because of this trade-off between the advantages of a tax shield and the costs of possible bankruptcy.
Risk and return:
Bonds are considered a more conservative investment with a lower risk level. First, bonds generally have fixed interest payments, and the investor knows the yield that he/she will earn if the bond is held to maturity. On the other hand, the return on a stock depends on the performance of the company. The investor can benefit from the firm's upside potential while carrying the risk of having a loss in case of less than the desirable performance of the company. Second, in case of the company's bankruptcy, the bondholders have the right to claim the assets before the stockholders. Therefore, bondholders have a higher possibility to salvage at least a part of their investment in case of a liquidation.
To sum up, investors need to consider their risk appetite when they make an investment decision. They shouldn't invest the funds that they can't afford to lose in risky assets. If a bond investment is considered, the bond's indenture should be explored to figure out whether there are protective covenants, collaterals, and other features that might affect the riskiness of the bond.