You're considering making an investment in a particular company. They have preference shares, ordinary shares, senior debt and junior debt.
Which is the safest investment? Which has the highest expected returns?
If a firm goes bankrupt, investors in different securities get paid back in this order:
- Senior debt
- Mezzanine debt
- Junior debt
- Preferred shares
- Ordinary shares
Ordinary stock holders get paid back last and only if there are any assets remaining, so they have the highest risk and deserve the highest return.
Senior debt gets paid first so it has the lowest risk and deserves the lowest yields (returns are usually called yields for debt).
A newly floated farming company is financed with senior bonds, junior bonds, cumulative non-voting preferred stock and common stock. The new company has no retained profits and due to floods it was unable to record any revenues this year, leading to a loss. The firm is not bankrupt yet since it still has substantial contributed equity (same as paid-up capital).
On which securities must it pay interest or dividend payments in this terrible financial year?
Coupon and principal payments on debt must be paid or else the firm will be forced to declare bankruptcy.
In most countries, corporate law only allows dividends on preferred stock and common stock to be paid out of retained profits. This prevents firms from issuing shares and simply paying shareholder's money back to them as dividends without actually investing in productive assets and earning any cash or profits, a common feature of Ponzi schemes.
Which business structure or structures have the advantage of limited liability for equity investors?
Corporations have the advantage of limited liability, so equity investors will never lose more than the amount that they have invested in the company. On the other hand, sole traders and partners can be sued and forced to sell their personal assets such as their house and property if the business's assets are insufficient to cover its liabilities.
Therefore sole traders', partners' and corporate shareholders' business equity are at risk. But sole traders' and partners' personal assets are also at risk whereas corporate shareholders' personal assets are safe due to limited liability.
Question 531 bankruptcy or insolvency, capital structure, risk, limited liability
Who is most in danger of being personally bankrupt? Assume that all of their businesses' assets are highly liquid and can therefore be sold immediately.
Darren has negative equity in his business. His business equity is -$7,000 since the business's liabilities of $10,000 are greater than its assets of $3,000. Since the business is a sole tradership rather than a company, Darren is personally liable for the business's debts.
Darren's non-business personal assets of $10,000 less personal liabilities of $6,000 net to $4,000. Therefore Darren's total personal wealth including the business is -$3,000 (=4,000-7,000), so he is most in danger of going bankrupt when the business's liabilities have to be repaid.
Notice that Billy's business also has negative equity of -7,000 (=3,000-10,000) and therefore his company is in danger of going bankrupt when its debts are due. However, since the business is a company, Billy will not be personally liable for those debts. He won't have to pay them, unlike Darren whose business is not a company.
Which one of the following businesses is likely to be a public company in Australia, judging by its name?
Australian public companies have limited liability, therefore the company name is always followed by the word 'Limited' or the abbreviation 'Ltd', such as Bloggs Ltd.
Private companies, also known as Proprietary companies, also have limited liability. To differentiate them from public companies, private companies' names are followed by the words 'Proprietary Limited' or the abbreviation 'Pty Ltd', such as Doe Pty Ltd. Sometimes this is further abbreviated to Doe P/L.
Question 452 limited liability, expected and historical returns
What is the lowest and highest expected share price and expected return from owning shares in a company over a finite period of time?
Let the current share price be ##p_0##, the expected future share price be ##p_1##, the expected future dividend be ##d_1## and the expected return be ##r##. Define the expected return as:
##r=\dfrac{p_1-p_0+d_1}{p_0} ##
The answer choices are stated using inequalities. As an example, the first answer choice "(a) ##0≤p<∞## and ##0≤r< 1##", states that the share price must be larger than or equal to zero and less than positive infinity, and that the return must be larger than or equal to zero and less than one.
Due to limited liability, shares in companies will never have a negative price. Therefore the lowest possible share price is zero. The highest possible share price is infinity, there's no limit to how much the shares could be worth. Therefore: ###0≤p<∞###
Returns are a function of price. The highest possible return is also infinite similar to price, but the lowest possible return will occur at the lowest possible future price of zero, so substituting ##p_1 = 0## and ##d_1 = 0## into the return formula: ###\begin{aligned} r &= \dfrac{p_1-p_0+d_1}{p_0} \\ r_\text{min} &= \dfrac{0-p_0+0}{p_0} \\ &= -1 \\ \end{aligned}###
So the lowest possible return is -1 which is -100%. This makes sense since you can't lose more than what you invest into the share. Therefore the bounds of returns are:
##-1≤r<∞##