Day 127 Debt capital

Debt capital

As we know, there are two types of capital in a corporation: debt and equity capital. As literally explain by their names, debt capital is derived from company borrowings and equity capital is the shareholder’s investment. Generally, debt capital will carry out more risks for the company, but it has relatively low cost to issue. Financial investors need to be aware of the difference between the debt and equity capital investment, in order to appropriately diversify our portfolios.

The debt securities could be divided into two categories: short –term securities and long-term bonds or debentures. The short-term securities have excellent liquidity and almost nil risks. However, the return can be quite low as well. Investors normally hold these securities temperately during the down turn of economy. To illustrate, bank deposits, treasury notes, certificate of deposit, commercial paper, bank-accepted bills and cash management trusts are typical short-term debt investments. The value of the security is calculated on the discount basis. Therefore, investors need to compute the bond equivalent yield (BEY) when comparing with interested basis investments.

The primary risk incurred by investing on short-term securities is the opportunity cost of higher return on other assets.

Another type of debt security is the long-term debt security. Bonds and debentures are the agreement of various organizations (i.e. government and company) to pay the certain amount on a specific date in the future. In addition, the interest payment will occur semi-annually before the maturity date. The bond price should be the present value of the investment after discounted the coupon payment subsequently. The formula is listed below:

As we may realize, the bond price reacts reversibly with the nominal interest rate. Which made the bond became the good portfolio stabilizer. It is also crucial for us to comprehend the ‘call feature’ of the bond. If the bond is freely-callable, the issuer may repurchase the bond at any time as to reissue them according to the interest rate variation. On the other hand, the non-callable and deferred call bonds put several restrictions over the call. At last, we need to acknowledge the rating of the bonds, which indicates the risk of default. Hence rational investors should only purchase bonds with at least Baa ratings. The major risk for long-term debt securities is the interest-rate risk, because the higher interest rate will reduce the bond price. Other risks such as liquidity, financial and call risks also require to be considered by the investors.