Principles of Managerial Finance

308 PART 2 Important Financial Concepts

capital
The long-term funds of a firm; all
items on the right-hand side of
the firm’s balance sheet, exclud-
ing current liabilities.

debt capital
All long-term borrowing incurred
by a firm, including bonds.

equity capital
The long-term funds provided by
the firm’s owners, the stock-
holders.

TABLE 7.1 Key Differences Between Debt and

Equity Capital

Type of capital

Characteristic Debt Equity

Voice in managementa No Yes

Claims on income and assets Senior to equity Subordinate to debt

Maturity Stated None

Tax treatment Interest deduction No deduction

aIn the event that the issuer violates its stated contractual obligations to them, debthold-

ers and preferred stockholders mayreceive a voice in management; otherwise, only com-

mon stockholders have voting rights.

LG1 7.1 Differences Between Debt and Equity Capital

The term capitaldenotes the long-term funds of a firm. All items on the right-

hand side of the firm’s balance sheet, excluding current liabilities,are sources of

capital. Debt capitalincludes all long-term borrowing incurred by a firm, includ-

ing bonds, which were discussed in Chapter 6. Equity capitalconsists of long-

term funds provided by the firm’s owners, the stockholders. A firm can obtain

equity capital either internally,by retaining earnings rather than paying them out

as dividends to its stockholders, or externally,by selling common or preferred

stock. The key differences between debt and equity capital are summarized in

Table 7.1 and discussed below.

Voice in Management

Unlike creditors (lenders), holders of equity capital (common and preferred

stockholders) are owners of the firm. Holders of common stock have voting

rights that permit them to select the firm’s directors and to vote on special issues.

In contrast, debtholders and preferred stockholders may receive voting privileges

only when the firm has violated its stated contractual obligations to them.

Claims on Income and Assets

Holders of equity have claims on both income and assets that are secondary to

the claims of creditors. Their claims on incomecannot be paid until the claims of

all creditors (including both interest and scheduled principal payments) have

been satisfied. After satisfying these claims, the firm’s board of directors decides

whether to distribute dividends to the owners.

The equity holders’ claims on assetsalso are secondary to the claims of cred-

itors. If the firm fails, its assets are sold, and the proceeds are distributed in this

order: employees and customers, the government, creditors, and (finally) equity

holders. Because equity holders are the last to receive any distribution of assets,

they expect greater returns from dividends and/or increases in stock price.