Question

Which ones of the followings are TRUE about debt and equity.

a. Debt provides an ownership interest.

b. Common stockholders have voting rights.

c. Interest is not considered a cost of doing business and is not tax deductible.

d. Creditors have legal recourse if interest or principal payments are missed.

e. A company can go bankrupt if it has too much equity.

Answer 1

Let us discuss which points are true and which not about debts and equity:

a. Debts are the mode for raising funds. Companies have usually two modes, by which they can raise money one is debt and other is equity. In debt, they borrow money from external sources like banks, or other financial instruments like debentures or by issuing bonds. Now, these instruments require to pay interest on them, and the company does not give the ownership rights or interests on debt instruments.

Whereas equity are the mode of raising funds which gives ownership rights to the shareholders of the company. They are also given the voting rights.

Hence the statement is false that debt provides ownership interest. Instead its the equity the provides ownership interest.

b. Common stockholders are shareholders of a company or can be said equity holders of a company. As we have mentioned above that equity holders have ownership rights. This means the equity holders also have got the voting right since being the owner.

So, it is true that the common stockholders are having the voting rights.

c. This is false. Interest paid may be on any debt instrument, be it loan, then the interest paid on these instruments are considered as a cost to the company because company has to pay them to their creditors. Thus anything company needs to pay is a cost for the company. And also these interest expenses are tax deductible. They can be deducted from the taxable income.

Thus, this statement is false.

d. Creditors are the one who have funded any organization or company with a view to get their money back in few years with the required interest on their amount. When an organization fails to repay back the amount to creditors, then creditors can take a legal action against the organization to get their amount back.

So, yes the statement is true that, creditors have legal recourse if interest or principal is not being paid to them.

e. This statement is false that if a company has too many equity then it can go bankrupt. Infact it should be such that if the company is having debts more then the equity, then there is a possibility that company can turn bankrupt.

Having too much debts is a sign that company is having high liabilities, which usually if not cleared turns the company bring bankrupt. But this is not true in case of having more equity.

Thus, the statement is false.