Securities issued by corporations may be classified roughly as equity securities and debt securities. At its crudest level, a debt represents something that must be repaid; it is the result of borrowing of money.
When corporations borrow, they promise to make regularly scheduled interest payments and to repay the original amount borrowed ( that is the principal). The person or firm making the loan is called the creditor or lender. The corporation borrowing the money is called the debtor or borrower.
From a financial point of view , the main differences between debt and equity are the following;
- Debt is not an ownership interest in the firm. Creditors generally do not have voting power.
- The corporation’s payment of interest on debt is considered a cost of doing business and is fully tax deductible.
- Unpaid debt is a liability of the firm. If it is not paid , the creditors can legally claim the assets of the firm.
This action can result in liquidation or reorganization, two of the possible consequences of bankruptcy. Thus , one of the cost of issuing debt is the possibility of financial failure. This possibly does not arise when equity is issued – Ross etal.