The Continuum between Debt and Equity

While the distinction between debt and equity is often made in terms of bonds and stocks, its roots lie in the nature of the cash flow claims of each type of financing. The first distinction is that a debt claim entitles the holder to a contracted set of cash flows (usually interest and principal payments), whereas an equity claim entitles the holder to any residual cash flows left over after meeting all other promised claims. While this remains the fundamental difference, other distinctions have arisen, partly as a result of the tax code and partly as a consequence of legal developments.

Hybrid Security: This refers to any security that shares some of the characteristics of debt and some characteristics of equity.

The second distinction, which is a logical outgrowth of the nature of cash flow claims (contractual versus residual), is that debt has a prior claim on both cash flows on a period-to-period basis (for interest and principal payments) and on the assets of the firm (in the case of liquidation). Thirdly, the tax laws have generally treated interest expenses, which accrue to debt holders, very differently and often much more advantageously than dividends or other cash flows that accrue to equity. In the United States, for instance, interest expenses are tax deductible, and thus create tax savings, whereas dividend payments have to be made out of after-tax cash flows. Fourth, debt usually has a fixed maturity date, at which point the principal is due, while equity generally has an infinite life. Finally, equity investors, by virtue of their claim on the residual cash flows of the firm, are generally given the bulk of or all of the control of the management of the firm. Debt investors, on the other hand, play a much more passive role in management, exercising, at most, veto power1 over significant financial decisions. These differences are summarized in figure 7.1.

Figure 7.1: Debt versus Equity

Fixed Claim Tax Deductible

High Priority in Financial Trouble Fixed Maturity No Management Control

Residual Claim

Not Tax Deductible

Lowest Priority in Financial Trouble

Infinite

Management Control

Debt Hybrid Securities Equity

Bank Debt Convertible Debt Owner's Equity

Commercial Paper Preferred Stock Venture Capital

Corporate Bonds Option-linked Bonds Common Stock

Warrants

To summarize, debt is defined as any financing vehicle that is a contractual claim on the firm (and not a function of its operating performance), creates tax-deductible payments, has a fixed life, and has a priority claim on cashflows in both operating periods and in bankruptcy. Conversely, equity is defined as any financing vehicle that is a residual claim on the firm, does not create a tax advantage from its payments, has an infinite life, does not have priority in bankruptcy, and provides management control to the owner. Any security that shares characteristics with both is a hybrid security.

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