Investment Decisions Chapter 7 Stock valuation
7.1 Differences between debt and equity
Debt – includes all borrowing incurred by a firm, including bonds, and is repaid according to a fixed
schedule of payments.
Equity – funds provided by the firm’s owners (investors or stockholders) that are repaid subject to
the firm’s performance.
Type of capital
Characteristics Debt Equity
Money obtained from Creditors who have legal right Investors who have only an
of being repaid. expectation of being repaid.
Voice in management No Yes
Claims on income and assets Senior to equity Subordinate to debt
Maturity Stated None
Tax treatment Interest deducted No deduction
7.2 Common and preferred stock
Common Stock
The true owners of a corporate business are the common stockholder, also residual owners, because
they receive what is left of income and assets.
They cannot lose any more money than they have invested in the firm.
- Ownership
The common stock of a firm can be
- privately owned by private investors.
The common stock of a firm is owned by private investors; this stock is not publicly traded.
- publicly owned by public investors.
The common stock of a firm is owned by public investors; this stock is publicly traded.
Private companies are often closely owned.
The common stock of a firm is owned by an individual or a small group of investors (family).
Public companies are widely owned.
The common stock of a firm is owned by many unrelated individual or institutional investors.
- Par value
The market value of common stock is completely unrelated to its par value.
The par value of common stock – an arbitrary value established for legal purposes in the firm’s
corporate charter and which can be used to find the total number of shares outstanding, by dividing
it into the book value of common stock.
- Preemptive rights
Preemptive right – allows common stockholders to maintain their proportionate ownership in the
corporation when new shares are issued, thus protecting them from dilution of their ownership.
Dilution of ownership – a reduction in each previous shareholder’s fractional ownership resulting
from the issuance of additional shares of common stock.
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7.1 Differences between debt and equity
Debt – includes all borrowing incurred by a firm, including bonds, and is repaid according to a fixed
schedule of payments.
Equity – funds provided by the firm’s owners (investors or stockholders) that are repaid subject to
the firm’s performance.
Type of capital
Characteristics Debt Equity
Money obtained from Creditors who have legal right Investors who have only an
of being repaid. expectation of being repaid.
Voice in management No Yes
Claims on income and assets Senior to equity Subordinate to debt
Maturity Stated None
Tax treatment Interest deducted No deduction
7.2 Common and preferred stock
Common Stock
The true owners of a corporate business are the common stockholder, also residual owners, because
they receive what is left of income and assets.
They cannot lose any more money than they have invested in the firm.
- Ownership
The common stock of a firm can be
- privately owned by private investors.
The common stock of a firm is owned by private investors; this stock is not publicly traded.
- publicly owned by public investors.
The common stock of a firm is owned by public investors; this stock is publicly traded.
Private companies are often closely owned.
The common stock of a firm is owned by an individual or a small group of investors (family).
Public companies are widely owned.
The common stock of a firm is owned by many unrelated individual or institutional investors.
- Par value
The market value of common stock is completely unrelated to its par value.
The par value of common stock – an arbitrary value established for legal purposes in the firm’s
corporate charter and which can be used to find the total number of shares outstanding, by dividing
it into the book value of common stock.
- Preemptive rights
Preemptive right – allows common stockholders to maintain their proportionate ownership in the
corporation when new shares are issued, thus protecting them from dilution of their ownership.
Dilution of ownership – a reduction in each previous shareholder’s fractional ownership resulting
from the issuance of additional shares of common stock.
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