Debt and equity: two different claims

Who gets paid, and in what order

A company's assets are financed by two broad groups of investors. Debtholders (lenders, whether through a loan or a bond) supply capital for a set period. Shareholders supply capital with no end date. Both are paid from the same stream of cash the assets generate, but not at the same time or on the same terms.

Revenue first pays for the inputs: suppliers for materials, employees for their work, lenders for interest and the government for taxes. Only the amount that remains, net income, belongs to shareholders. The board then decides how much of it to pay out as dividends and how much to keep in the business as retained earnings.

The same ordering applies if a company is wound up. Its assets are sold and the proceeds go to the priority claimants first. Shareholders receive something only if value is left over after everyone else has been paid in full.

What lenders get

A lender's claim is fixed and finite: the issuer promises specific interest and principal payments on specific dates, and the relationship ends at maturity (three months or thirty years, but it ends). Missing a promised payment is a default, with legal consequences.

Lenders have no say in how the company is run. Instead they write protection into the contract: financial requirements the borrower must keep meeting (for example a minimum ability to cover interest, or a cap on borrowing) and, sometimes, a legal claim on specific assets if the debt is not repaid.

Because the claim is senior, fixed and limited in time, debt is less risky for the investor than equity. Investors therefore accept a lower expected return, which makes debt the cheaper source of financing for the issuer.

What shareholders get

Equity is permanent capital: the company never has to give it back. Nothing is promised to shareholders. They own the residual claim: whatever cash flow and assets remain after expenses, investment needs and debt payments.

Distributions are at the discretion of the board of directors. A board can cut or skip a dividend without any default. In exchange for bearing this uncertainty, shareholders get control: they vote on major matters, above all on who sits on the board, which in turn hires and oversees management.

The tax difference

Interest is usually an expense deducted before taxable income is calculated, so every unit of interest also reduces the tax bill. Dividends are paid out of after-tax profit and give no such saving.

This makes debt cheaper still on an after-tax basis. The after-tax cost of borrowing at 8% when the tax rate is 25% is $8\% \times (1 - 0.25) = 6\%$. The higher the tax rate, the bigger the saving and the more attractive debt becomes relative to equity, all else equal.

A quick way to remember the whole lesson: lenders get a promise, priority and a tax break for the issuer; shareholders get a vote and whatever is left.