Activity 12 Purpose: DEBT vs. EQUITY Identify the characteristics of debt and equity Assess financial risk Corporations externally finance the purchase of assets with debt (liabilities) or equity (common stock). Assets Liabilities + Stockholders' Equity Large amounts of debt are usually issued in the form of bonds. The borrowing corporation records bonds payable and is referred to as the debtor and the entity loaning the money records a bond receivable and is referred to as the creditor. The debtor must pay back the amount borrowed plus interest to the creditor. The interest paid by the borrowing corporation is an expense that reduces taxable income. The return to creditors is the interest received. Creditors are not owners of the corporation, and therefore, have no ownership rights. Equity refers to the issuance of stock, which may be common stock or preferred stock. Entities owning shares of stock are the owners of the corporation and are referred to as stockholders or shareholders. Stockholder's primary ownership rights include a right to vote at annual meetings and a right to a portion of the profits (net income). Dividends are the distribution of profits to stockholders. The corporate board of directors decides whether to pay dividends or not and has no obligation to purchase the shares of stock back from the stockholders. If stockholders sell their shares of stock, they usually sell to another investor using a stockbroker, who in turn executes the trade on a stock exchange such as the New York Stock Exchange or NASDAQ Stockholders earn a return on their investment by receiving dividends or selling the stock for a greater amount than the purchase price. The balance sheet helps investors, both creditors and stockholders, assess the degree of financial risk a corporation is assuming. In general, the more a corporation relies on debt to finance assets, the greater the financial risk of the corporation. $ in millions 12/31/2005 Assets Liabilities Stockholders' equity Debt ratio Google (GOOG). $10.272 $ 853 General Motors (GM) $ m $448,239 $ (B) $ 15.425 % Q1 Compute the values for (B) and (Y) in the above chart. Compute the Debt Ratio and record in the above chart. This ratio quantifies the proportion of assets financed with debt. Debt ratio Liabilities/Assets (Google/GM) is financing assets primarily with debt; therefore, (Google/GM) is assuming the greater financial risk. Based only on the information presented above, which company would you choose as an investment? (Google/GM) Why? Q2 For each item circle the correct response when comparing the issuance of debt and equity. a. b. c. The corporation (has to / does not have to) pay interest to creditors, but (has to / does not have to) pay dividends to shareholders. The corporation (must/never has to) repay amounts borrowed from creditors, but (must/never has to) repay amounts invested by shareholders. The interest expense of debt (reduces/ does not reduce) taxable income, but dividends paid to shareholders (reduce / do not reduce) taxable income. d. Issuing additional debt (does / does not) dilute shareholder's ownership rights, but issuing additional shares of common stock (does / does not) dilute shareholder's ownership rights. If you were the CFO of a large company, how would you recommend financing assets? Primarily with (debt/equity). Why? If this was a small company? Primarily with (debt/equity). Why? c Interpreting and Analyzing Financial Statements 4 Page 18 Chapter 2-Balance Sheet