Corporate Finance, 4th Edition

Chapter 34Debt, equity and options theory

Light too bright to see by

The theories of corporate finance examined so far may have given the impression that the only difference between debt and equity is the required rate of return. However, there is a big difference between the 10% return required by creditors and that required by shareholders.

Shareholders simply hope to achieve this rate, which forms an average of rates that can be either positive or negative. The actual return can range from 0% to infinity, with the entire range of variations in between!

Creditors are assured of receiving the required rate, but never more. They can only hope to earn the 10% return but, with a few exceptions, this hope is almost always fulfilled. So here we have the first distinction between creditors and shareholders: the probability distribution of their remuneration is completely different.

That said, although the creditor's risk is very low, it is not nil. Capitalism is built on the concept of corporation, which legally restricts shareholders' liability with respect to creditors. When a company defaults, shareholders hold a “trump card” that allows them to hand the company, including its liabilities, over to the lenders.

The main financial innovation of the 19th century is the corporation.

In the rest of this chapter, we will concentrate on the valuation of companies in which shareholders' responsibility is limited to the amount they have invested. This applies to the vast majority of ...