Question

BE9-1 Bali Corp. has $10,000 in surplus funds to invest and is considering investing in either Company A or Company B. Company A promises to return the $10,000 original amount invested in three years’ time and pay a 2% annual return on the principal amount. Company B does not promise to repay the original amount invested, but indicates that it is likely that the $10,000 investment will be worth more than $10,000 if Company B is profitable. Whether Bali will receive an annual return on the investment depends on Company B’s cash flows and whether Company B’s board of directors votes to distribute the cash. (a) Identify whether the potential investments are investments in debt or in equity securities. (b) Explain how you determined your answer.

Answer 1

Question a)

Investment in company A is an investment in debt.

Investment in company B is an investment in equity.

Question b)

Debt is an instrument of fixed return. When you give a debt to a company, irrespective of how the company is doing, whether it is earning a profit or not, it will have to pay you back the principle amount and the interest along with it. Debt is also given for a specified period, within which the whole principle amount along with interest is to be paid. There is significantly lesser risk involved in debt compared to equity.

Equity investment gives you ownership of the company, however the company is not bound to pay you returns if it is incurring losses. Also, it might not give you dividends, even if it earns profits. There is no obligation for the company to pay dividends. It depends on whether the company chooses to do so. If the board of directors resolve to distribute dividends, then the equity shareholders will get dividends. But generally, the owners have some sort of control over the board of directors and will get paid dividends if there are profits. Unlike debt, the dividends can vary annually depending on the magnitude of profits made by the company. The shareholders also get voting rights.

Company A pays a fixed 2% return annually on principal, irrespective of the profit made by the company. Hence it is debt.

Returns from Company B depend on the profits and whether the board elects to distribute dividends. Hence it is equity.