Financial Accounting Theory and Analysis, 15th Edition

15Equity

Equity is the value shareholders would receive if all assets were liquidated, and all debts repaid. It is the core risk capital of a company, lacking guaranteed returns or a repayment schedule. A key feature of equity is its permanence, contributing to enterprise stability and resilience against insolvency. Through economic cycles, equity remains invested, providing a stable financial foundation. During prosperous times, it fuels growth and expansion. In challenging periods, it acts as a financial cushion, absorbing losses and supporting the business.

Investors deciding whether to purchase a company's common stock must weigh the risk of loss associated with the company's existing debt against the potential for higher profits from using financial leverage. The combination of a company's debt and equity capital is known as its capital structure.

Over the years, considerable debate has emerged regarding whether a firm's cost of capital varies with different capital structures. Financial theorists and researchers have proposed theories and examined empirical evidence to determine if varying mixtures of debt and equity in a firm's capital structure impact the firm's value. For example, prominent economists Modigliani and Miller theorized that, aside from the tax deductibility of interest, an enterprise's cost of capital is unaffected by the mix of debt and equity.¹ According to their theory, this holds true because individual shareholders can adjust their own level of risk ...