Difference Between Debt and Equity

We can classify a financial instrument according to the type of claim the investor has on the issuer. A financial instrument in which the issuer agrees to pay the investor interest, as well as to repay the amount borrowed, is a debt instrument or simply a loan. The issuer is required to pay interest payments which are contractually fixed. U.S. In the case of debt instruments requiring payment in dollars this amount may be a fixed dollar amount or a percentage of the face value of the loan or may vary depending on some benchmark. An investor who lends funds and expects interest and repayment of the loan is a creditor of the issuer.

The key point is that an investor in a debt instrument cannot borrow more than the contractual amount. As such, debt instruments are often referred to as fixed income instruments.

The Walt Disney Company bonds issued in July 1993, which mature in July 2093, bear interest at a rate of 7.55%. That means Disney pays investors who buy the bonds $7.55 a year for every $100 of debt they own.

An equity instrument against a debt obligation specifies that while the issuer pays the investor an amount based on earnings, the issuer must make the loan after paying off the liabilities to the company's creditors. Common stock and partnership shares are two examples of equity instruments. Common stock is an ownership interest in a corporation, while a partnership share is an ownership interest in a partnership. We refer to any distribution of a company's earnings as a dividend.

At the end of 2008, Procter & Gamble, a US consumer products company, had 3032717 shares outstanding. At that time financial institutions owned almost 60% of this stock. These financial institutions include both pension funds and mutual funds. The rest of Procter & Gamble's stock was owned by individual investors.

Some financial instruments fall into both categories depending on their properties. A preferred stock is a hybrid stock as it resembles a debt as investors in this security are entitled to receive only a fixed contractual amount. Yet preferred stock is similar to equity in that payments to investors are made only after the company's debt obligations are met.

We refer to preferred stock as a fixed income instrument because preferred stockholders are generally entitled to a fixed contractual amount. Hence fixed income instruments include debt instruments and preferred stocks.

A convertible bond or convertible note is also called another hybrid instrument. A convertible bond or note is a debt instrument that allows an investor to convert into shares of common stock under certain conditions and at a certain exchange ratio.

The classification of debt and equity becomes important for two legal reasons. The first is that investors in debt instruments have priority over equity investors in their claims on the assets of the issuer. Second, the tax treatment of payments by issuers in the United States varies by class type. In particular, interest payments on debt instruments are tax deductible to the issuer, while dividends are not.

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