In Practice A Financing Checklist for Classifying Securities

Some new securities, at first sight, are difficult to categorize as either debt or equity. To check where on the spectrum between straight debt and straight equity these securities fall, answer the following questions:

1 The veto power is usually exercised through covenants in bond agreements.

1. Are the payments on the securities contractual or residual?

• If contractual, it is closer to debt

• If residual, it is closer to equity

2. Are the payments tax deductible?

3. Do the cash flows on the security have a high priority or a low priority if the firm is in financial trouble?

• If it has high priority, it is closer to debt.

• If it has low priority, it is closer to equity.

4. Does the security have a fixed life?

5. Does the owner of the security get a share of the control of management of the firm?

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