Subject 4. The Risks of Creditors and Owners

Creditors and stockholders bear different risks because they have different rights and responsibilities.

  • Creditors get pre-determined returns and principals back when due, regardless of the profitability of the firm.
  • Stockholders get what is left over after all expenses, including interest paid to creditors, have been paid. In exchange for this uncertainty of returns (which is the risk that stockholders face), stockholders exercise decision-making power over the business. They can also declare what portion of the business earnings they will take out as dividends.

The use of greater amounts of debt in the capital structure can raise both the cost of debt and the cost of equity capital.

  • The higher the percentage of debt, the riskier the debt, hence the higher the interest rate creditors will charge.
  • In general, increasing the use of debt increases the expected rate of return, but more debt also means that the firm's stockholders must bear more risk. The cost of equity capital must be higher now than before.

Creditors have priority over stockholders in a bankruptcy proceeding. When a firm files for bankruptcy, its leverage often determines the final outcome.

  • Reorganization. A firm with high financial leverage uses bankruptcy laws and protection to reorganize its capital structure to remain in business.
  • Liquidation. A firm with high operating leverage cannot use such bankruptcy protection, as it would not reduce operating costs. This means that the firm's business is terminated, all the assets are sold and distributed to the holders of claims on the organization, and no corporate entity should survive. Stockholders generally lose all value in such a case, and creditors typically receive a portion of their capital.

User Contributed Comments 12

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mabrickley: So if a company does a stock split, how does the company create revenue since its traded in the 2ndary market. Other words, what financial gain does a company receive for doing a stock split
quynhnk79: The stock price usually go up soon after the split.
steved333: There is no immediate financial gain for the company. What it does is signal to investors that they are a strong company. Would you want to do business with a company that no one has faith in? It's all about image. The more investors like you, the more willing people are to do business with you. So the financial benefit for the company may not come directly from the 2ndary market trading, it comes from the ongoing business that results from the confidence that consumers have based on its reputation among its investors. Sort of like word-of-mouth marketing.
steved333: And if the company needs more money later from outside investors, its reputation and strong stock will be more likely to sell in a seasoned offering.
highheat: Also, a higher stock price would have some other benefits. For example, companies often use stock to replace cash in acquisitions. And then you can also take into consideration that many of their executive compensation come from stock options.
atikusz: A stock split might also be simply necessary!.. looing at from stock price optimization perspective. too expensive stock - drives away many investors.
bmeisner: The best example of this is Berkshire Hathaway. Each share of voting stock costs over 100k USD. Most companies would do a split to attract more investors but Warren Buffet doesn't as a sign of just how much his shares have appreciated over time. Still, most people can't afford his stock - extreme example.
VenkatB: Can someone verify my understanding of this concept.

Share value = $10
A 100% stock dividend is equivalent to 2 for 1 stock split. However stock split is not a way to pay the dividends.

100% Stock dividend

A shareholder of one share will get an additional share and now his total share value = $10 +$10 = $20

2 for 1 split:

A shareholder of one share will get two shares each worth ($10/2= $5) and the total share value is still $10, it doesn't change.

The key point here is : stock split is done for totally different reasons , it is not a means to pay the dividends.
mazen1967: right
michlam14: i remember someone said stock splits makes the stock more affordable to investors, at the point of the split there is actually no benefit - infact it dilutes the shares but outside investors can now afford to buy, which can drive up the price
papajeff: Stock splits have no dilutive effects. If Apple split 2 for 1, the shareholders would have twice as many shares worth half as much. Effect on investor sentiment is debateable. Warren Buffet obviously doesn't feel there is an advantage to keeping the nominal share price low, who am I to argue?
uipshawj: @VenkatB: the stock split does not increase/decrease value, a 2 to 1 or 4to1 drops the price and creates more shares. so 1 share at $50 split 2-1, stockholder now has 2 shares at $25, same value more shares. It can also go the other way, ie Citi (C) reverse split, 100 shares at $10 would turn into 50 shares @$20. Companies do this to increase analyst coverage and institutional investment.