Question

Why might an investor prefer to invest in a company's equity rather than its debt?

Answer 1

Answer:

An investor may prefer to invest in a company's equity rather than its debt because of the following reasons:

1. Residual interest and developed secondary market: Equity holders have a residual interest in the assets of the company. This means that they will get some payment only in the event of liquidation. Thus, the risk of loss of capital is low. Further, there is an organised and regulated secondary market (the stock market) from which he can expect his investment to maintain price buoyancy. He may sell off his stock holdings if he needs to exit his investment but debt does not provide this benefit and generally has to be held till maturity.

2. Higher return on equity: In case of equity, the investor has a higher return expectation in the form of capital appreciation and dividend. It is viewed as more risky and the investor might have a better risk appetite and tolerance to take it up. The general principle which the risk tolerant investor perceives as true is  'higher rthe risk, greater the return' though in reality, it may have the downside of greater loss.

3. Principal / Capital and interest default risk: Though debt ensures fixed return there is some degree of default risk attached. There is always a risk that the company may not be able to pay the fixed interest in some years or may default on some or all of its capital commitments or repayment of debt whereas in case of equity the risk is deferred to a contingent situation of liquidation of the company.

4. Tax friendly / benefits: Historically tax legislations worldwide accord better treatment or favour to capital appreciation or gains on stocks which are taxed on realization and that too may be after indextaion of the cost of acquisition rather than debt which is taxed on accrual of interest, the result of which is lower tax on equity which can be seen as another reason for preferring investment in company's equity rather than debt.

5. Flexible investment horizon: There is flexibility in the holding period of equity whereas debt has a fixed holding period and may not fit in with the short or long term investment objectives of the investor.