Unravelling the Credit Crunch : [PDF Download]

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“One key difference between equity and debt is that the obligation to pay interest on debt is usually binding: if a firm cannot meet interest or principal payments, it will be forced to default.

Dividend payments are entirely optional: firms have complete discretion in paying these, and there may well be no payments if the firm makes losses. Typically at maturity the best thing that can happen to a bond holder is that they are paid the expected amount.

An equity holder has a claim on the entire value of the firm after all other claims have been met. The value of this claim – the equity price – can go up arbitrarily far if the corporation’s profits increase faster than its liabilities.

Equity holders expect the most return because they take the most risk: their claim is subordinated and dividends are discretionary. Moreover the funding they have provided is perpetual: a share lasts as long as the company does, and is never repaid.”

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