Principles of Managerial Finance

CHAPTER 7 Stock Valuation 309

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As is explained in Chapter 11, the costs of equity financing are generally

higher than debt costs. One reason is that the suppliers of equity capital take

more risk because of their subordinate claims on income and assets. Despite

being more costly, equity capital is necessary for a firm to grow. All corporations

must initially be financed with some common stock equity.

Maturity

Unlike debt, equity capital is a permanent formof financing for the firm. It does

not “mature” so repayment is not required. Because equity is liquidated only dur-

ing bankruptcy proceedings, stockholders must recognize that although a ready

market may exist for their shares, the price that can be realized may fluctuate.

This fluctuation of the market price of equity makes the overall returns to a firm’s

stockholders even more risky.

Tax Treatment

Interest payments to debtholders are treated as tax-deductible expenses by the

issuing firm, whereas dividend payments to a firm’s common and preferred stock-

holders are not tax-deductible. The tax deductibility of interest lowers the cost of

debt financing, further causing it to be lower than the cost of equity financing.

Review Question

7–1 What are the key differences between debt capitaland equity capital?

7.2 Common and Preferred Stock

A firm can obtain equity, or ownership, capital by selling either common or pre-

ferred stock. All corporations initially issue common stock to raise equity capital.

Some of these firms later issue either additional common stock or preferred stock

to raise more equity capital. Although both common and preferred stock are

forms of equity capital, preferred stock has some similarities to debt capital that

significantly differentiate it from common stock. Here we first consider the key

features and behaviors of both common and preferred stock and then describe

the process of issuing common stock, including the use of venture capital.

Common Stock

The true owners of business firms are the common stockholders. Common stock-

holders are sometimes referred to asresidual ownersbecause they receive what is

left—the residual—after all other claims on the firm’s income and assets have

been satisfied. They are assured of only one thing: that they cannot lose any more

than they have invested in the firm. As a result of this generally uncertain posi-

tion, common stockholders expect to be compensated with adequate dividends

and, ultimately, capital gains.