Debt and Equity Risk and Reward
By Members Desk
April 4, 2022
0:00 / 1:57

So what's the difference between debt and equity debt tends to be a safer investment because you have a senior claim on the assets of a company and it comes in lots of different forms. You've hoarded mortgage debt on a home. That's a secured loan secured by a house, but you can have mortgage debt on a building for a company there's senior debt.

There's junior debt. There's mezzanine debt there's convertible debt bottom line its all debt. It comes in different orders of priority and a company. And your, the rate you charge is in, you know, is inversely related to your securities. So the better the security and the less risk, the lower, the interest rate you're entitled to receive.

The more junior, the loan, the higher, the interest rate you're entitled to receive, but you don't, you can avoid the complexity. All you need to think about is debt comes first. It's a safer loan, but your profit opportunity is. Now the equity also, they're very informed. There's something called preferred equity or preferred stock.

There's common equity or common stock. And again, stock and equity are basically synonyms they're options, but really not worth talking about today. The important point is the equity gets everything that's left over after the debt's paid off. So it's called a residual claim, now the good thing about the residual claim is that business grows in value.

You don't own your owe your lenders anymore. But all that value goes to the stockholder. So the question is why was the lender willing to take only a 10% return when the equity earned a much higher rate of return? And the answer is when the business started, there was no way of knowing whether it would be successful.

And the lender made a bet that if the business failed well, they could sell it. Eliminate Stan costs $300 to make it that would have some lemons, some lemonade, even if they sold at a much lower price than the dollar they originally projected. The lender felt pretty comfortable that they get their money back.

Whereas the stockholder is really taking a risk. They were betting on the profitability of the company and they were taking a risk that if it failed, they would lose their entire investment. So they're entitled to get a higher return. All right. Have the potential to have a higher return in the event, the business was successful.